15. Company analysis and company valuation methods Flashcards
Company analysis and valuation methods
The following methods are considered:
P/E Ratio Method
Relative Value Method
Dividend Valuation Method
Capital Asset Pricing Method
Shareholder Value Analysis Method
Economic Value added Method
Total Shareholder Return
Market Value added Method.
P/E ratio
P/E Ratio = Market Price/EPS
Value of a Share = EPS x Appropriate P/E Ratio
Conditions for applying P/E ratio
Should be from the same industry with similar :
Company Risk
Financial Risk
Growth Rate.
Investment valuation ratios
Investment valuation ratios compare relevant data that will estimate the attractiveness of a potential or existing investment. Investors assess the performance of a company’s shares by looking at how ratios compare from one company to another.
In all of these ratios, we are referring to equity (ordinary) shares, as we have already excluded any preference dividends. In doing this we are guided by the IAS 32 (Financial Instruments: Representation) requirement that preference dividends are an expense and that preference shares are a liability (not part of equity).
From an equity shareholder’s point of view, the relevant information will be
contained in the following ratios.
Dividends
dividend payout ratio (DPR)
dividend yield
Earnings
earnings per share (EPS)
price/earnings ratio (P/E)
Dividend payout ratio
This ratio measures the earnings attributable to equity shareholders that are paid out in the form of dividends. A higher payout ratio indicates that the company is sharing more of its earnings with its equity shareholders. A lower payout ratio indicates that the company is using more of its earnings to retain in the company to reinvest and grow further.
The payout ratio depends on company policy and the industry in which it operates. For example, fast-growing companies have a lower DPR as earnings are retained for expanding market share.
DPR = Equity dividend(s) paid in the year ÷ Profit for the year × 100
Dividend yield
Dividend yield indicates how much a company pays out in dividends each year relative to the equity share price. Normally, only profitable companies pay out dividends. A stable dividend yield can be a sign of a stable and safer company.
It allows investors to compare the annual cash return with other investments. Of course, the return from equity is a combination of the annual dividend and capital growth. This refers to dividends paid in the year, which are normally last year’s final dividend payment and the current year’s interim dividend payment.
Dividend yield = Dividend(s) per share ÷ market price per equity share ×
100
Earnings per share
Earnings per share (EPS) can be defined as the residual profit (or earnings) attributable to each equity shareholder. Residual profit means the profit for the period after charging interest and other finance charges, corporate tax, preference dividends and any transfers to other component of equity. The balance is the profit available for equity shareholders (usually reported as profit after tax or profit for the period/year).
This is the basic measure of a company’s performance from an equity shareholder’s point of view, calculated as profit attributable to each equity share.
EPS = profit attributable to equity shareholders for the period ÷ weighted average number of outstanding equity shares during the period.
International Accounting Standard 33 (Earnings per Share) prescribes how quoted companies should calculate their EPS figures. These figures should be published at the base of a statement of profit or loss and OCI by all quoted companies. The very detailed level of prescription on IAS 33 is to ensure consistent calculation of EPS so investors can rely on consistent P/E ratios.
Interpretation of EPS
If revenue indicates how much money is flowing into the company, EPS indicates how much money is ultimately attributable to the equity shareholders. It serves as an indicator of the profitability of the company that tells us how much money the company is making on every individual outstanding equity share.
The higher the EPS, the more attractive the shares will be to potential investors and higher the stock market value. An appreciating EPS trendindicates the growth of a company. Investors can also look at the estimates of future EPS to get an idea of the profits they will earn in future years.
A high EPS indicates a company in good health, with enough profits available to pay dividends to the equity shareholders or to plough back into the company for future prospects and long-term growth. A company with a reported loss gives a negative EPS which is usually reported as ‘not applicable’.
EPS is a measure of the management performance. It shows how effectively the available capital and opportunities have been fully utilised in the reporting period.
It sets an upper limit for dividends, which some consider to be an important determinant of share price – although users should be aware that dividends are sometimes financed from distributable profits from previous years.
Earnings per share changes when the level of profit increases or decreases. In addition, EPS will be altered or diluted when there is a new share issue, giving rise to the calculation of basic EPS and diluted EPS. Basic EPS is profit attributable to equity shareholders for a period, divided into the weighted average number of outstanding equity shares for that same period. Diluted EPS is the adjusted attributable profit for a period, divided into the outstanding equity shares and adjusted to include all potential dilution. A diluted EPS assumes that all the convertible securities such as convertible preferred shares, convertible debt, equity options and warrants will be exercised. Diluted EPS is generally less than basic EPS.
Limitations
Earnings per share does not represent actual income to the shareholder. It uses earnings, which are not directly linked to the objective of maximising shareholder wealth.
Companies have the option to buy back their shares. In this case, the number of shares outstanding decreases, increasing the EPS without an actual increase in the profit. Companies can make EPS look better without profit actually improving.
EPS does not consider the debt element of the company. It may not be an ideal comparison of two companies where one company has debt and the other company does not.
EPS trend analysis shows the growth of a company in recent years. However, it may not be meaningful to compare EPS of different companies. The figures are dependent on the number of shares and their nominal value, that each company has in issue. Different companies are also likely to have different accounting policies.
Price/earning ratio
The price/earnings (P/E) ratio, also referred to as the ‘earnings multiple’ of a
company, measures the current market price of the share relative to its EPS. The
current market price is driven by the forces of supply and demand along with
overall stock market performance.
P/E ratio = Market price per share ÷ EPS
This ratio indicates the relationship between the market value of equity share
capital and the profit for the year. The P/E ratio valuation method is a simple
and commonly used method of valuation. This approach uses the price earnings
ratio of a similar quoted company to value shares in unquoted companies.
Value of a share = EPS × suitable industry P/E ratio
The P/E ratio applied should be from the same industry, with similar:
company risk (in the same industry)
finance risk (a similar level of gearing)
growth rate
This may be difficult to achieve in practice. The P/E ratio used is often negotiated
between parties involved in the acquisition. If using a quoted company’s P/E
to value an unquoted company, a substantial discount (around 25%) is often
applied to reflect the lower marketability of unquoted shares.
Interpretation of price/earning ratio
The P/E ratio gives a stock market view of the quality of the underlyin earnings. Generally, a high P/E ratio indicates that investors anticipate higher earnings and higher growth in the future. The average market P/E ratio has often been stated at 20–25 times earnings. In reality, different markets at different times may have averages well above or well below this range. A P/E ratio is most useful when compared with a benchmark: for
example, the average P/E ratio for a specific sector of a market.
A loss-making company does not have a P/E ratio.
A company with a high P/E ratio can indicate that the equity shares are being overvalued. If a company has a high P/E, investors are paying a higher price for shares compared to its earnings.
A company with a low P/E may indicate undervalued shares. This can
make a company with a low P/E a good value investment with potential
opportunity to be profitable, but it can also simply indicate that investors
are not confident about the company’s future prospects.
The P/E ratio shows the number of years it would take for the company to
pay back the amount an investor paid for the share. In other words, the
number of multiples over one year’s earnings an investor is willing to pay
for a share.
Limitations of P/E ratio
The P/E ratio is applied to earnings based on accounting policies, which are more subjective than cash flows. A company can inflate their earnings to make them look better.
The P/E ratio simply assumes that the market is valuing earnings and ignores many important variables in an equity share’s worth: dividends, earnings growth, risk and so
on.
The P/E ratio assumes that the market accurately values equity shares.
The P/E ratio is actually a backward-looking indicator, providing little help where economic conditions have changed significantly.
It does not consider debt. Companies with high debt levels are higher risk investments and the market price of an equity share is not always a good indicator of fair value.
The P/E ratio is a useful valuation method used by investors, but it should never be used as the sole reason for investing in a company.
Relative value measures
Relative value is a method of determining an asset’s value that takes into account the value of similar assets of competing companies in the same industry. This is in contrast with other valuation methods, which look only at an asset’s intrinsic value and do not compare it to other assets. It is based on the approach that the investors are not just interested in the absolute figures on the financial statements, but also in the valuation of the asset in relation to its peers.
The investor measures share value (or the attractiveness measured in terms of
risk, liquidity and return) in relation to a comparable share of another company.
Steps in relative value analysis
- Identify comparable companies. Revenue and market capitalisation are the
widely used parameters. - Calculate price multiples such as P/E ratio, equity share price to sales
revenue and equity share price to operating cash flow. - Compare these ratios with those of peers and the industry average.
This will help in understanding whether the security is overvalued or
undervalued.
Valuation using the dividend
valuation model
The dividend valuation model (DVM) – also known as the dividend discount
model (DDM) – is based on the principle that the current value of an equity
share is the discounted value of all expected dividend payments that the share is
expected to yield in the future years. The NPV is calculated using an appropriate
risk-adjusted rate that discounts the value of future cash flows to today’s date.
This discount rate (see Chapter 12) is also referred to as the cost of capital for
equity and the cost of capitalisation. It is the rate of return expected by the
equity shareholders as compensation for the risk of owning and holding the
shares.
Future cash flows would include dividends and the selling price of the share
when sold. For shares that do not pay dividends, the future cash flows would be
equal to the intrinsic value of the selling price of the share.
Current intrinsic value of an equity share = sum of present value of all
future cash flows
Sum of present value of all future cash flows = sum of present value of
future dividends + present value of the share price
Assumptions:
The future income stream is the dividends paid out by the company.
Dividends will be paid in perpetuity.
Dividends will be constant or growing at a fixed rate.
Valuable growth model
In a real-life scenario, dividends paid by companies do not remain constant over a number of years. The variable growth model – also known as the dividend growth model – divides the dividend growth into three phases:
an initial phase of fast growth;
a slower transition phase; and
a sustainable ‘long run’ lower growth rate.
This model is a refinement of the DVM, but the basic principles remain the same. The capitalisation factor (the required rate of return) and the dividend growth rate might
vary in these three phases. The intrinsic value of the share is the PV of each of these stages added together.
Different investors and analysts might have different predictions about the
company’s future dividends, which might lead to different growth rates and
required rates of returns. The exact intrinsic value of the share is indeterminable
in most cases.
Growth rate (g) = r × b
Where:
r = annual rate of return from investing
b = the proportion of annual earnings retained
