Valuation of Companies and 9 key definitions
After skimming through The Fast Forward MBA in Finance, Second Edition by John Tracy, a few key concepts (such as EPS, ROE, market capitalisation and P/E) kept coming up again and again when dealing with the value of companies. When read in combination with Joel Greenblatt’s book, The Little Book That Beats the Market which simplifies things to some degree, an understanding of these concepts is required to begin understanding whether a company is undervalued or overvalued on the stock exchange and hence whether you should invest in the company.
It is important to firstly recognise that the value of a company’s shares on the stock exchange is only a representation of what the public will pay at any particular time for a stake in the company and is not a direct representation of the company’s true value per se. This fact is actually why smart investors should always be able to make money investing the stock market. For example, if an investor is able to identify a under or overvalued company, they can make the appropriate decision to either buy the stock if it is undervalued or sell the stock (we’ll come to how you can sell stock you don’t have later) if it is overvalued. Over time, whether it is overnight or over 5 years, the market will correct itself and the investor will profit from his analysis of the companies true value compared with the market’s perception of its value.
In later posts, I will describe how Greenblatt’s book proposes a magic formula strategy for identifying undervalued companies based on a company having a high earnings yield and a high return on capital. Firstly, however, this post will aim to explain these concepts so that we can get familiar with them first. Some of the definitions below are drawn from Tracy’s glossary in The Fast Forward MBA in Finance, Second Edition.
Earnings per share (EPS)
As a fairly straight forward concept to begin with, if you have ever read typical stock trading journals such as the Wall Street Journal, you will have seen the EPS ratio is reported regularly. It is crucial to understand this concept as one of many which will allow you to estimate the true value as opposed to the market value of a company. Expressed as a ratio, a company’s EPS is equal to the net income for a period, usually one year, divided by the number of shares issued by the company (typically on a stock exchange for a public company). Net income is considered to be a company’s earnings before interest and income taxes (EBIT) in the calculation of the earnings yield in Greenblatt’s book (discussed below).
Despite being a rather straightforward concept, there are several technical problems in calculating earnings per share as two EPS ratios are needed for many companies— basic EPS, which uses the actual number of capital shares outstanding, and diluted EPS, which takes into account additional shares of stock that may be issued for stock options granted by a company and other stock shares that a company is obligated to issue in the future. Additionally, many companies report not one but two net income figures (due to varying gains and losses) and issue more than one class of capital stock, which makes the calculation of their earnings per share quite complicated in some scenarios.
EPS is thus measured in a variety of different ways.
Return on assets (ROA)
Although there is no single uniform practice for calculating this ratio, generally it equals operating profit (before interest and income taxes – EBIT) for a year divided by the total assets that are used to generate the profit.” ROA is the key ratio to test whether a company is earning enough on its assets to cover its cost of capital. ROA is used for determining financial leverage gain (or loss).”
Return on equity (ROE)
“This ratio, expressed as a percent, equals net income for the year divided by owners’ equity. ROE should be higher than a company’s interest rate on debt.”
Return on capital (ROC)
The method used by Greenblett is calculate the ratio of pre-tax earnings (EBIT) to tangible capital employed (net working capital +Net fixed assets) which is claimed to be more representative of a company’s position than the alternative methods since it allows you to “view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels”. Alternative methods involve dividing return on equity (ROE) by equity or return on assets (ROA) by assets (these concepts are explained below) and these measures are quite common as they are the typically reported measures.
Price/earnings (P/E) ratio
This key ratio equals the current market price of a capital stock share divided by the earnings per share (EPS) for the stock. The EPS used in this ratio may be the basic EPS for the stock or it’s diluted EPS, depending on which method is desired to be used.
A low P/E may signal an undervalued stock or may reflect a pessimistic forecast by investors for the future earnings prospects of the business.
A high P/E may reveal an overvalued stock or reflect an optimistic forecast by investors. High P/E’s were typical in the technology boom of the late nineties and early 21st century before the dot com crash.
The average P/E ratio for the stock market as a whole varies considerably over time—from a low of about 8 to a high of about 30. This is quite a range of variation and must be read in combination with other information to give a good indication of the true value of a company.
Greenblett states that the basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business. One way to arrive at the earnings yield is to divide a company’s earnings per share (EPS) for the year by its share price, leaving you with a ratio representative of the earnings yield; the P/E ratio discussed above).
Greenblett’s preferred method is again take the EBIT and divide it by the enterprise value (market value of equity + net interest bearing debt) to arrive at a figure that allows the comparison of companies with different levels of debt and tax rates on the same platform for examination. Please see the earnings yield example for this calculation in practice.
These methods will be discuss in the later post about the formula in The Little Book That Beats the Market. For now, I mean only to introduce these concepts.
Other key concepts
Market capitalization (MC)
The total MC is equal to the current market value per share of capital stock multiplied by the total number of shares in a public company. This value often differs widely from the book value of owners’ equity reported in a business’s balance sheet.
Book value and book value per share
These terms refer to the balance sheet value of an asset (or less often of a liability) or the balance sheet value of owners’ equity per share. The total of the amounts reported for owners’ equity in its balance sheet is divided by the number of stock shares of a corporation to determine the book value per share of its capital stock.”
Return on investment (ROI) A very general concept that refers to some measure of income, earnings, profit, or gain over a period of time divided by the amount of capital invested during the period. It is almost always expressed as a percent. For a business, an important ROI measure is its return on equity (ROE), return on assets (ROA) and return on capital (ROC) discussed above.
Whilst I realise that I am far from an expert yet, I hope the collation of these definitions will lay the foundations for understanding how to differentiate between the true value of a company and its market value.
I am most welcome to any comments if I have made any errors above.
If you are interested in how companies go about finding capital or fundraising, please see another James Cox blog on fundraising and investment through IPOs and private equity.
Click here for a look at Company Valuation methodologies like multiples and discounted cashflow analysis.