Company analysis and company valuation methods Flashcards
Investment valuation ratios?
Investment valuation ratios?
There is a wide array of ratios that can be used by investors and shareholders to evaluate the performance of a company’s shares and assess its valuation.
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, what ratios do they use?
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)
What is a dividend payout ratio?
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
What is a Dividend yield?
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
Worked example 15.2 shows how these ratios are applied in practice
What is Earnings per share?
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.
Worked example 15.2 shows how EPS is applied in practice
Interpretation of EPS
- The higher the EPS, the more attractive the shares will be to potential investors and higher the stock market value.
An appreciating EPS trend indicates 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.
When does earnings per share change?
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.
Diluted EPS = adjusted profit attributable to equity shareholders for a period ÷ weighted average number of outstanding equity shares + diluted shares
For example, a company with a profit for the year of £6 million and 2 million equity shares also has convertible debt that
could be converted to 1 million equity shares.
- Basic EPS = £6,000,000 ÷ 2,000,000 = 300p/share.
- Diluted EPS = £6,000,000 ÷ (2,000,000 + 1,000,000) = 200p/share
Limitations to EPS?
Limitations to EPS?
- 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/earnings ratio?
Price/earnings 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/earnings ratio?
Interpretation of Price/earnings ratio:
- The P/E ratio gives a stock market view of the quality of the underlying 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.
5.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 to Price/earnings ratio?
Limitations to Price/earnings 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.
6.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.
Worked example 15.1 - P/E ratio
Worked example 15.1
- The shares of Good plc are currently trading at £42. Its EPS for the most recent 12-month period is £3. Calculate the P/E ratio.
P/E ratio = £42 ÷ £3 = 14 times
For every £1 of earnings from the company’s profits, the investor has to invest £14 in the company’s shares.
Put another way, the payback period is 14 years, based on the current share price and current earnings.
Worked example 15.1 continued…..Share price
- From the latest set of financial statements of ABC Ltd (a small printing company) it can
be calculated that its basic EPS is 50p and the average P/E ratio of similar quoted printing companies is currently 20.
What is the price per share for ABC Ltd?
Value of a share = EPS × suitable industry P/E ratio
Price per share = £0.50 × 20 = £10
Test yourself 15.1
Test yourself 15.1
The shares of Sira plc are trading at £30 and the company has an EPS of £2 over the last year.
- Calculate the P/E ratio.
P/E ratio = Market price per share ÷ EPS
£30 ÷ £2 = 15 times
Test yourself 15.1 continued - interpretation
- How is the P/E ratio used and interpreted by investors?
The P/E ratio is a widely used tool for stock analysis and investment decisions.
Investors use this ratio for their own
perceptions about the market and make decisions to buy or sell accordingly.
The P/E ratio is compared with those of its
competitors and with the industry average.
The P/E ratio gives a stock market view of the quality of the underlying 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 is 20–25 times
earnings.
A loss-making company does not have a P/E ratio.
However, a company with a high P/E ratio can also indicate that the share is being overvalued.
If a company has a high P/E, investors are paying a higher price for the share compared to its earnings.
A company with a low P/E may indicate undervalued shares.
This makes 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 aren’t very 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 paid for the share.
