An ordinary investor who wishes to be successful in investing should invest in good companies. However, if you purchase the best stock in the world at a lofty premium, it may not be a good investment. Vice versa, the stock of a mediocre company, if bought cheaply enough, could work out to be a profitable investment.
Warren Buffet invested in Coca-Cola in 1987. 1st July 1990, the share price was $5.69. At earnings of 30 cents per share, PE was only 19, a fair price to pay for a company that grew its earnings at a CAGR of 13.4% over the next 8 years to 82 cents a share in 1998. The share price grew at a much faster rate at a CAGR of 29% over the next 8 years to $42.59. The PE ratio in 1998 expanded to 52.
From July 1998 to July 2019, the EPS grew by 83%, a CAGR of 2.9% only. Its share price barely grew 22.6% to $52.2 per share or a CAGR of 1% only. The PE has contracted to 35. Those investors who bought Coca-Cola, a great company at its peak price 20+ years ago, way underperformed the broad market during the same period. Valuation matters. the price you pay determines your return on investment.
Relative Valuation
The common method used for valuation, or rather pricing by retail investors, professional analysts, and investment bankers alike is what is termed relative valuation. The metrics used are:
1. Price – earnings ratio
2. Price-to-book ratio
3. Dividend yield
4. Price-to-cash flows
5. Price-to-sales
6. Enterprise value to EBIT or EBITDA
Price-to-Earnings (PE) Ratio
The PE ratio is the most widely used valuation metric.
PE ratio = Price (P$) / EPS = Market Cap / Net Income
Market Cap = Price x number of shares
It is effectively shorthand for how expensive or cheap a share is compared with its profit. The PE ratio is the number of years an investor needs to get back his capital investing in a stock. For many, this probably is the only metric they use when investing. EPS results and estimates about the future are easily available from many financial data sources.
Flipping the PE ratio over, we have a ratio of E/P, this is what we call earnings yield which we can compare with the yield or return of alternative investments such as bank Fixed Deposits. As investing in a stock incurs higher risk than FD in a bank, it is natural that we would expect a higher yield than the FD rate of say 3%-4%, and hence a lower PE ratio.
Some value investors take on the Cyclically Adjusted PE (CAPE) ratio, which is the current price divided by the average earnings per share over a cycle of 7-10 years. Sometimes current earnings can be overly inflated due to a business boom, or overly depressed in an economic downturn.
The most useful way to use a PE ratio is to compare it with a certain benchmark. Good benchmarks are the PE of other companies in the same industry, the PE of the entire market, or the same company’s PE at different points in time. Each of these approaches has some value as long as you know the limitations. Keep in mind that using PE ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when an entire industry or entire market will become overvalued.
The PE ratio valuation of stock given by the market depends on the growth prospect of the company too. Stocks with high PEs usually have greater future growth prospects. The higher the growth of earnings, the shorter the period investors will recoup their initial capital, i.e. the price they pay.
When you are looking at the PE ratio, also make sure that the “E” part of the equation makes sense and is representative of a company’s ongoing profits. A few things can distort the PE ratio. A company may book a big one-time gain from the sale of a division: property, plant, and equipment; gain in foreign exchange, boosting reported earnings. These are one-off earnings that should be adjusted in evaluations.
The quality of earnings which are translated to cash flows is important. If the cash flows are poor every year with earnings piled up higher and higher in receivables, resulting in the ballooning of its debts. Following that, the PE ratio, in general, is that it does not take a company’s debt into account, and in a value investing situation, that’s a serious shortcoming that makes comparing leveraged companies like-for-like almost impossible. This is where the EBIT Mulitple for the whole firm or earnings of the entire firm compared with enterprise value comes in.
Other factors that can affect the PE valuation are the market position of the company, management credibility and capability, and its good capital allocation, risks, etc. Furthermore, there are different kinds of PE ratios used in market analysis: trailing PE, which uses the past four quarters’ worth of earnings, and forward PE which uses analysts’ estimates of the next four quarters’ earnings to calculate the ratio. Investing is about future earnings but estimates are often way off.
PEG: Price to Earnings Growth
Price-to-Earnings Growth (PEG) ratio was popularised by Peter Lynch. It is used to counter the problems of companies with different expected growth rates.
PEG = PE ratio/Growth rate
PEG takes into consideration the growth of the company which the previous earnings-based valuation doesn’t. By dividing the PE Ratio by the forecasted EPS growth rate, an investor can compare the relative valuation of each more comfortably.
This type of valuation is particularly applicable to young companies. When Facebook was listed in 2011, the market value was estimated at $50 billion. Based on the estimated earnings of $500 million then, PE ratio was 100. This value seems excessively expensive. Its earnings grew by a CAGR of 45% for the next 7 years from 500 million to 6900 million in 2018. Its market capitalization increased 11-fold to 550 billion.
It is generally accepted that a PEG ratio of under 1 signifies growth at a reasonable price. But if a stock has an expected growth of 50% in the next few years, paying a price of 50 times its present earnings may not be a wise move, especially since the extremely high expected growth is just an expectation rather than an actual outcome in the future.
Price-to-Book Ratio
The book value or Net Asset Backing (NAB) is the net equity position left over when everything a company owes is taken away from what it owns.
Price-to-Book ratio (P/B)
= Market Cap/ Equity attributed to common shareholders
= Price/ NAB
NAB = Net Asset Backing per share
It is worth noting that this book value often includes assets such as goodwill and patents which aren’t tangible like cash, receivables, inventories, plant, property, and equipment. Some investors remove such “intangible” assets from calculations of the P/B ratio to make the more conservative Price to Net Tangible Asset (P/NTA).
The P/B ratio does not rely on volatile measures like profits as asset value does not change much year-on-year. It has a hard accounting foundation in the company’s books and hence has often been used as the key barometer of value by academics.
Some Value Investors try to buy stocks at a discount to their Book Value or when P/B ratio is less than 1. However, the stock market assumes a going concern of the business and not its winding down. P/B may not be applicable for an asset-light company where its value is heavily dependent on its intangible assets and earnings power. For these types of companies, a price-to-book value of less than 3 may be considered as cheap.
The P/B ratio is also tied to return on equity. Comparing two equal companies, the one with a higher ROE will be accorded a higher P/B ratio. If the ROE is above the cost of equity, the business is traded at a higher P/B value and vice versa. The P/B ratio is useful for the valuation of banks in which the assets and liabilities are marked to market and revalued every quarter. A firm that can compound book equity at a much higher rate is worth far more because absolute book value will increase more quickly.
Price-to-Cash Flow
The price-to-cash flow ratio offers investors a somewhat more useful look at a company’s value than the PE ratio because the price-to-cash flow ratio uses a denominator that focuses on cash flows from operations, or Free Cash Flow (FCF) after capital expenses.
Price-to-CFFO = Market Cap / CFFO
Price-to-FCF = Market Cap / FCF, flip it over to get
Cash Yield or Cash Return = FCF / Market Cap
CFFO = Net Cash Flows from Operations
FCF = Free Cash Flow
Cash flows are very lumpy numbers as in certain years, depending on the cyclicality and growth dynamic of the business, there may be more build-up of inventories, receivables, and higher capex. Be sure to take an average of cash flows over a few years, say 5 years or so. Also bear in mind that a fast-growing company may have lower cash flows, even for many years, but that does not mean it is bad.
Another way to remove the disruptive volatility of cash flow is to use the operating cash flow before a change in working capital, or cash earnings. The adjustment can be done as follows:
Cash Earnings = Net Profit + Depreciation and Amortization +/- Non-Cash and Non-Operating Items
As FCF is hard cash, a price-to-FCF of 20 or a cash yield of 5% may be a good benchmark.
No earnings: Price-to-Sales Ratio
The ratio was popularized by Kenneth Fisher. During the Dotcom euphoria in the late 1990s, many new technology companies mushroomed. Their share prices were chased sky-high, but they had no earnings at all. So this valuation technique was widely used then.
Price-to-Sales, P/S = Market Cap/ Revenue
Sales unlike profit are the least susceptible to accounting manipulation. While earnings can vary from year to year, sales are much more stable. As a result one of the more popular approaches is to look at the stock’s Price to Sales Ratio. This ratio got a bad name when it was abused during the dot-com bubble to justify the nosebleed valuations, but it does remain a key indicator for isolating potential turnaround stocks.
Price-to-sales is linked to profit margin. Look out for stocks with historically reasonable margins trading on a P/S ratio of less than 1. Technology companies are valued at a much higher P/S ratio. Twitter went public in November 2013 and was valued at a price 12.4 times its estimated 2014 sales. Facebook 11.6 times and LinkedIn 12.2 times. LinkedIn was acquired by Microsoft.
P/S is easy to compute and understand, and a more appropriate measure should be using the enterprise value instead of market cap over sales to be consistent in both the numerator and denominator, as sales are for the whole business.
Dividend Yield
The dividend yield is one of the oldest valuation methods. It was very popular back in the days when dividends were the primary reason people owned stocks, and it is widely used today, among income-oriented investors.
Dividend Yield (DY) = Dividend per Share / Share Price
A dividend yield of 4% would mean that the stock is undervalued as it is above the bank fixed deposit rate, notwithstanding that most stocks have growth potential, FD has none.
As with all valuation ratios, dividend yield must be used with caution. Stocks with very high dividend yield might seem like bargains but these companies are often going through financial problems that have caused their stock price to plunge. It is not unusual for companies in such situations to cut their dividend to save cash, so their actual dividend yield going forward might be lower than the currently reported figure.
A company may not have any growth potential if it pays out most of its earnings and cash flows as dividends. It is good to look for companies with increasing dividends over the years but with a payout ratio of less than 75%.
Which valuation technique to use?
As you can see, there are various relative valuation methods that investors can use to determine if a stock is cheap or expensive, each with its own merits and pitfalls. The choice of which of these valuation ratios to use will come down to the situation at hand. Some companies are consistently profitable (use P/E or Earnings Yield E/P), some have more consistent cash flow than profits (use P/FCF), some are losing money on their sales (use P/S) or have no sales to speak of but do have hard assets (P/B), while others are a bit pricier but are cheap for their growth (use PEG). For banks with assets and liabilities marked-to-market (use P/B).
By understanding this array of value factors you will be far better placed to turn over different stones when circumstances favour it. Remember, the return on your investment depends solely on the price you pay. This is the second part of the puzzle for you to invest in the stock market to build long-term wealth safely and surely. Next, we will look at the valuation of a company at its firm-level based on enterprise value.
Enterprise value looks at the value of the entire firm, for capital both provided by equity shareholders and by the debt holders, and at the same time separating those assets not required or not used for the core operations of the business. It may appear to be a little harder for most investors to comprehend and use, but it is not insurmountable.
Enterprise Value and Entity Multiples
For a company without much cash and debt, and without those non-operating one-time-off items, it may be adequate to use the PE ratio to determine in relative terms if the stock is worthwhile to invest in. However, as many companies have substantial amounts of cash or debts in their balance sheets, and often with some extraordinary gain/loss or other one-time off items, the use of the simplistic PE ratio would have missed the forest for the trees.
Consider this: Two identical companies A and B in the same industry have the same number of shares with the same share price and market capitalization of 100 million as shown below. Company A has a total debt of 50 million and an excess cash of 10 million, whereas B has a total debt of 10 million but an excess cash of 20 million.
Both companies make a net income of 10 million. Hence both A and B are selling at a price-earnings of 10 (100 million/ 10 million). But are the two companies any different? Which company would you prefer to invest in? The simplistic PE is useful as a crude screening tool but it has a serious limitation of ignoring the balance sheet items. This can misinterpret the earnings yield of a business.
One way to look at it is to consider the Enterprise Value (EV) of A and B and see which business would be cheaper to buy. Enterprise value is equivalent to the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company’s debt but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm’s value. The value of a firm’s debt, for example, would need to be paid by the buyer when taking over a company, EV provides a much more accurate takeover valuation because it includes debt in its value calculation.
EV of a Firm = Market Capitalization + Debt + Minority Interest – Cash – Other Non-Operating Assets
Market capitalization is the market value of the common shareholders’ equity equaled to the number of shares multiplied by the share price.
The debts are the market value of interest-bearing bank loans, bonds, etc. In financially solid businesses, the market value of debt corresponds to its book value.
Minority Interest (MI) is the result of the consolidation of the subsidiary company’s account and it does not belong to the common shareholders of the company. The market value of MI is obtained by multiplying its book value by an appropriate price-to-book value.
Cash and cash equivalents are deducted from the enterprise value as they lower the purchase price. They can be distributed or used for the reduction of debts in an acquisition. The other non-operating assets such as investments in other companies, listed or non-listed, money market funds, and investments in associates, are treated in a similar way as cash or cash equivalent as they can be sold without impacting its core business.
EV = Market Cap + Debt – Cash
EV of A = 100 + 50 – 10 = 140 million
EV of B = 100 + 10 – 20 = 90 million
We can see debt and cash have an impact on the company’s enterprise value. Company A is more expensive than Company B. When evaluating the fair value of the company, a better measure of value is the enterprise value over the Earnings Before Interest and Tax (EBIT) or the operating income.
Entity Multiples
Relative valuation using entity multiples takes into consideration the price of the entire firm, or the enterprise value, in relation to the revenue and earnings of the whole firm. They include EBIT, EBITDA, sales multiple, etc. The numerators and denominators are consistent with each other, that are at the entire firm level.
EBIT Multiple
EBIT is Earnings before Interest and Tax, sometimes called operating income. EBIT multiple is particularly suitable for comparisons of business across industries and serves as a central valuation when taken together with P/E and P/B ratios. EBIT multiple considers the capital structure of the firm.
EBIT Multiple = EV/EBIT
EBIT Multiple of A = 140/ 15.8 = 8.9
EBIT Multiple of B = 90/ 13.8 = 6.5
For an ordinary firm, an EBIT multiple of less than 8 may be considered cheap, whereas for a high-growth company, an EBIT multiple of 15 may be considered as fairly value.
EBITDA Multiple
For highly indebted businesses, the EBITDA is used by all capital providers to have an idea of the earnings available at their disposal for investments and interest payment, as well as comparison among companies in a similar industry. The EBITDA figure is not normally listed in the Income Statement, but we can add the depreciation and amortization figures in the cash flows statement to EBIT or operating income.
EBITDA = EBIT + Depreciation and Amortization
EBITDA Multiple = EV/ EBITDA
This valuation metric resembles cash flows and is useful for companies with negative earnings. It is a quick and dirty way for a leverage buy out to value a target and to see how much leverage could slap on a company and still service the debt.
An EBITDA multiple of less than 11 for an ordinary company may be considered as cheap.
Sales Multiple
This multiple has been discussed in Price-to-Sales ratio, except this should be the more appropriate valuation as both the numerator and denominator are at the entire firm level and hence consistent with each other.
Sales multiple = EV / Sales
Earnings Yield
We flip the ratio of EBIT Multiple of EV/EBIT over, we get the ratio EBIT/EV which we term as Earnings Yield (EY) of the enterprise.
EY (before tax) = EBIT / EV
EY of A = 15.8 / 140 = 11.3%
EY of B = 13.8 / 90 = 15.3%
The EY of B at 15.3% is clearly higher than the 11.3% of A. B is a cheaper buy than A.
The EY computation above is pre-tax EY which is good enough for comparison among companies. Use after-tax EY so that I can compare it with other alternative investments.
EY (after tax) = EBIT x (1 – tax rate) / EV
EY (after tax) of A = 15.8 x (1-25%) / 140 = 8.5%
EY (after tax) of B = 13.8 x (1-25%) / 90 = 11.5%
Earnings Yield allows us to see how cheap a stock is. Unlike discounted cash flow analysis, calculating a stock’s current earnings yield requires no estimates into the future. Earnings Yield is the main valuation tool to compare the relative price-value relationship of companies in the same industry to see which one is a better buy, similar to what we have to the company A and B as seen above. For individual cases, we will be happy to invest in a company with a normal growth rate of say 5% with an after-tax earnings yield of 12%.
Investors should make the ratio of a company’s EV/EBIT a primary tool to evaluate its earnings power and to compare it to other companies. For cyclical companies that have debts, it is more appropriate to use entity multiple rather than based on PE ratio. Entity multiples are better market valuation metrics than PE and other ratios for just the common shareholders as discussed. However, they are all relative and comparative metrics, what we can the intrinsic value. We can compare the market price with the intrinsic value and determine the margin of safety to give us better decision-making in stock investment.
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