Company valuation is performed to determine if a stock is worth buying from a business valuation perspective. We compare the company’s worth to its stock price.
The best approach is to use a number of valuation metrics and then see if they are all in the same ball park. If the stock is cheap based on a number of different measures then it might be worth buying (all other things considered). Let’s look at company valuation . . .
Why is it so important to buy a stock at a cheap price?
The price you pay for a stock determines how much you’ll earn. Your return is the difference between your purchase price and your sell price. The greater the difference between your purchase price and your sell price, the greater your return.
Your return also includes the dividend payments you receive whilst you own the shares.
If a stock is already overpriced, what’s to say that it will go higher. If a stock is cheap, then the most likely direction for it to go is up (provided your analysis indicates a strong upside potential).
Successful investing is all about buying great companies at attractive prices.
What are the most common valuation measures?
Company valuation metrics usually come in one of the following flavors:
- Multiple-based measures
- Typically, this involves comparing the stock price to a figure that represents one aspect of a company’s worth.
- The benefit of multiple-based measures is that most of them can be compared to other companies in the same industry, the industry as a whole, and the company’s historical values.
- Yield-based measures
- A measure of the income return of the investment.
- The benefit of yield-based measures is that they can be compared to other types of investments such as bonds and bank term deposits etc.
- Forecasting-based measures
- A measure of value based on the likely future returns of cash flows or earnings.
- The benefit of forecasting-based measures, such as a Discounted Cash Flows valuation, is that they take the current price out of the equation. This can be useful, but you need to be very careful with this type of valuation because it’s based on a number of estimates about the future circumstances of the company that may or may not be correct.
Common multiple-based valuation measures
Price / Earnings ratio
The Price / Earnings (P/E) ratio is a common stock valuation metric. It uses the current stock price as the numerator and the earnings per share (EPS) figure as the denominator.
In theory, the lower the P/E ratio the cheaper the stock. In practice though, companies with a P/E ratio of five or less may have experienced some sort of unusual earnings event in the previous year. It might be safer to leave those stocks alone.
For a P/E ratio to have any merit, the earnings per share figure used needs to be scrutinized.
If the firm has sold any assets or taken any big charges recently the earnings figure could be skewed. This is why professional investors “normalize” earnings.
Normalization is a process of adjusting figures so they more accurately represent the true reality of the business. When performing stock analysis, earnings need to sourced from the company’s core operations not from:
- The sale of assets
- Investment income
- Merger and acquisition advantages, or
- Other one-time events
Normalization may also involve adding back to earnings any one-time charges (i.e. large extraordinary outflows of cash).
There are two versions of the P/E ratio:
- The trailing P/E ratio which uses the EPS figure from the last annual report, and
- The forward P/E ratio which uses an EPS figure based on analysts estimates of next year’s earnings.
The trailing P/E ratio is probably a better measure of value because it’s based on actual reported earnings and not an estimate. Forward P/E ratios also tend to be too optimistic to be useful.
Because the P/E ratio is based on earnings, an accrual accounting-based measure of profit, the P/E has some drawbacks. It can however be useful in stock screening and quick “back of the envelope” calculations.
Price / Book Value ratio
The Price / Book Value ratio (P/BV) was popularized by the father of modern investment analysis – Benjamin Graham. Back in his day, publicly listed companies usually had a large asset base from which they drove their earnings and cash flows. It made sense to value companies by comparing their stock price to the value of the assets listed on the company’s balance sheet.
In theory, if the market capitalization of a company is less than the value of the assets on the balance sheet then the stock is cheap.
Market capitalization is the overall value of a company on the stock market. It’s calculated by multiplying the number of shares outstanding (i.e. the number of shares available on the market) by the current stock price.
Price / book value can be a useful ratio for valuing companies that have a large asset base or companies that derive their income from assets (i.e. financial companies). But for service companies and others that don’t need a substantial asset base from which they drive earnings and cash flows, price / book value isn’t useful.
Just as the P/E ratio needs its earnings figure to be scrutinized, so too do a company’s assets if you intend on using the price / book ratio.
A better version of the price / book ratio is the Price / Net Tangible Assets ratio (P/NTA). This is simply the price / book ratio with intangible assets removed from the denominator. Intangible assets such as goodwill, patents, trademarks etc, may add some sort of value to a firm, the problem is that this value can’t easily be measured so we ignore it in the P/NTA ratio.
From a valuation perspective, the lower the price / book value, the cheaper the stock.
Enterprise Value / EBITDA
The enterprise value to EBITDA multiple compares the “take-out” value of a company to its underlying earnings.
Let’s start with some definitions . . .
Enterprise value represents what you would pay if you intended to buy a publicly listed company – the whole thing. This is the price you’d pay if you wanted to take the company off the stock market.
Enterprise Value = Market Capitalization + (Total Debt – Cash)
In case you’re wondering, we subtract cash from total debt to arrive at the “net debt” figure. Net debt is probably a better representation of a company’s debt than the debt figure alone. Theoretically, if the company wanted to, they could use their unused cash to pay off some of their debt.
EBITDA stands for: Earnings Before Interest Tax Depreciation and Amortization. It is a measure of profit that is useful for making comparisons between companies.
EBITDA is sometimes listed in company reports. To calculate EBITDA yourself, locate the company’s statement of financial performance. Take the operating profit before tax figure. Add net interest (“interest payments” minus “interest receipts”) and you have the EBIT. Then add the depreciation and amortization expenses and you’re done.
Like most multiples, the lower the Enterprise Value / EBITDA the better. Typically investors look for multiples between four and eight to represent a cheap stock.
Common yield-based valuation measures
Dividend yield is another tool in company valuation. It is a useful number as it allows you to compare investment returns for different types of investments.
Not all companies pay dividends. Some companies prefer to pile those funds back into the business. I usually insist on dividend paying stocks. I buy stocks because I think the share price will rise and I’ll be able to sell at a profit. If I get paid dividends along the way then I have something else boosting my overall investment return.
If a company can consistently pay dividends, then it says a lot about the strength of that company. The percentage dividend paid is usually set according to what the Board of Directors of the company consider to be the long-term growth rate of the company.
And while dividends are a good thing, we need to ensure that the company isn’t paying too much out in dividends. A good company will leave some money in the kitty to fund the company’s growth. A dividend payout ratio less than seventy percent is preferred.
Dividends act a price stabilizer. This is how it works. If the stock price drops, the dividend yield will rise. This attracts income investors who buy stocks for the dividends they provide. The income investors buy the stocks with the high dividend yields and in doing so, push the stock price up.
Dividend Yield = Dividend Per Share / Share Price
From a valuation perspective, the higher the dividend yield the cheaper the stock.
Free Cash Flow Yield
As we learned in previous lessons, free cash flow is often a prelude to higher earnings and therefore a higher stock price.
Free Cash Flow Yield is considered by many to be one of the best stock valuation measures because it incorporates a number of critical factors all in the one measure.
Free cash flow yield tells us how much free cash flow a company is generating compared to the firm’s intrinsic value (i.e. enterprise value).
Free Cash Flow Yield = Free Cash Flow / Enterprise Value
Free Cash Flow = Cash Flow from Operations – Capital Expenditures
Enterprise Value = Market Capitalization + (Total Debt – Cash)
Like all yield-based valuation measures, the higher the free cash flow yield the better.
Forecasting-based valuation measures involve making estimates about the likely future cash flows of a company, and then discounting those values back to the present to arrive at a valuation.
The most popular forecasting valuation measure is called Discounted Cash Flows (DCF).
The problem with DCF is that it’s based on estimates, and slight differences in estimates can cause the final valuation to swing widely.
I’m not an advocate of DCF but I wanted to mention it so that you have some awareness of it.
The best valuation approach
If you use a number of different measures to value a stock you’ll increase your chances of success.
Of the valuation measures we’ve covered, I tend use P/E ratios for stock screening. I don’t put too much weight in price earnings ratios by themselves though. They are convenient and do provide a quick and nasty valuation (if you can believe the earnings component).
As a rule of thumb, I like a dividend yield somewhere near five percent.
If the company is fairly asset intensive then I will also look at how P/NTA is tracking compared to its historical values.
I rely more on enterprise value to EBITDA and free cash flow yield than anything else. If I had to choose out of these two measures I’d pick free cash flow yield because free cash flow is my preferred measure of profit, and being a yield-based measure it can easily be measured to other types of measures.
- Buying a company at a cheap price improves your chances of success
- Understand the pros and cons of each of the valuation measures used. Read widely.
- Valuation measures based on estimates can be fraught with danger
- Use multiple measures to value a company
- Continue on to Lesson 11: The Investment Decision