Valuation: Principles & Practice
|How to Read a Balance Sheet||
So just how do you value the shares of a company? Based on earnings, revenues, cash-flow. . . or something else entirely? Or do you simply apply multiple valuations in order to discern what the fair price for a share of stock might be? In this series of informative articles by MF Templar, Fools get a chance to learn lots of potential ways to value a company's shares, as well as helpful methods to determine whether or not a stock is undervalued right now.
|Introduction To Valuation
Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, she can make informed decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in a sea of random short-term price movements and gut feelings.
For years, the financial establishment has promoted the specious notion that valuation should be reserved for experts. Supposedly, only sell-side brokerage analysts have the requisite experience and intestinal fortitude to go out into the churning, swirling market and predict future prices. Valuation, however, is no abstruse science that can only be practiced by MBAs and CFAs. Requiring only basic math skills and diligence, any Fool can determine values with the best of them.
Before you can value a share of stock, you have to have some notion of what a share of stock is. A share of stock is not some magical creation that ebbs and flows like the tide; rather, it is the concrete representation of ownership in a publicly traded company. If XYZ Corp. has one million shares of stock outstanding and you hold a single, solitary share, that means you own a millionth of the company.
Why would someone want to pay you for your millionth? There are quite a few reasons, actually. There is always going to be someone else who wants that millionth of the ownership because they want a millionth of the votes at a shareholder meeting. Although small by itself, if you amass that millionth and about five hundred thousand of its friends, you suddenly have a controlling interest in the company and can make it do all sorts of things, like pay fat dividends or merge with your company.
Companies buy shares in other companies for all sorts of reason. Whether it be an outright takeover, in which a company buys all the shares, or a joint venture, in which the company typically buys enough of another company to earn a seat on the board of directors, the stock is always on sale. The price of a stock translates into the price of the company, on sale for seven and a half hours a day, five days a week. It is this information that allows other companies, public or private, to make intelligent business decisions with clear and concise information about what another company's shares might cost them.
The share of stock is a stand-in for a share in the company's revenues, earnings, cash flow, shareholder's equity -- you name it, the whole enchilada. For the individual investor, however, this normally means just worrying about what portion of all of those numbers you can get in dividends. The share of ownership entitles you to a share of all dividends in perpetuity. Even if the company's stock does not currently have a dividend yield, there always remains the possibility that at some point in the future there could be some sort of dividend.
Finally, a company can simply repurchase its own shares using its excess cash, rather than paying out dividends to shareholders. This effectively drives up the stock price by providing a buyer as well as improving earnings per share (EPS) comparisons by decreasing the number of shares outstanding. Mature, cash-flow positive companies tend to be much more liberal in this day and age with share repurchases as opposed to dividends, simply because dividends to shareholders get taxed twice.
This series of articles will take you through the major methods for valuing companies. The main categories of valuation I will elucidate are valuations based on earnings, revenues, cash flow, equity, dividends and subscribers. Finally, I will sum this all up in a conclusion that positions these valuations in the broader context of fundamental analysis and gives you a sense of how to apply these in your own investment efforts.
Transmitted March 3, 1997
EARNINGS PER SHARE AND THE P/E RATIO
The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS).
You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has one million shares outstanding and has earned one million dollars in the past 12 months, it has a trailing EPS of $1.00. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported.)
$1,000,000 -------------- = $1.00 in earnings per share (EPS) 1,000,000 shares
The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15.
$15 share price --------------------------- = 15 P/E $1.00 in trailing EPS
IS THE P/E THE HOLY GRAIL?
There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this group of unFoolish investors blindly plunge ahead armed with this one ratio, purposefully ignoring the vagaries of equity analysis. Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value), the P/E has been oversimplified by those who only look at this number. Such investors look for "low P/E" stocks. These are companies that have a very low price relative to their trailing earnings.
Also called a "multiple", the P/E is most often used in comparison with the current rate of growth in earnings per share. The Foolish assumption is that for a growth company, in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth.
In our example of XYZ Corp., for instance, we find out that XYZ Corp. grew its earnings per share at a 13% over the past year, suggesting that at a P/E of 15 the company is pretty fairly valued. Fools believe that P/E only makes sense for growth companies relative to the earnings growth. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months, the P/E becomes less useful than other valuation methods we will talk about later in this series. In the end, P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error.
ARE LOW P/E STOCKS REALLY A BARGAIN?
With the advent of computerized screening of stock databases, low P/E stocks that have been mispriced have become more and more rare. When Ben Graham formulated many of his principles for investing, one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. Today, all you have to do is punch a few buttons on an online database and you have a list as long as your arm.
This screening has added efficiency to the market. When you see a low P/E stock these days, more often than not it deserves to have a low P/E because of its questionable future prospects. As intelligent investors value companies based on future prospects and not past performance, stocks with low P/Es often have dark clouds looming in the months ahead. This is not to say that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -- you still can and it happens all the time. Rather, you need to confirm the value in these companies by applying some other valuation techniques.
THE PEG AND YPEG
The most common Foolish applications of the P/E are the P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG). Rather than reinvent the wheel, as there is a wonderful series of articles already written on these very subjects in Fooldom, I will simply direct your attention to them and talk about them very briefly. The full article on the PEG and YPEG, titled "The Fool Ratio," can be found in the "Fools & Their Money" area.
The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable to both an acquirer and a shareholder seeking either dividends or free cash flow to fund stock buybacks, this makes some degree of intuitive sense. Only looking at the trailing P/E is kind of like driving while looking out the rearview mirror.
If a company is expected to grow at 10% a year over the next two years and has a P/E of 10, it will have a PEG of 1.0.
P/E of 10 ---------------------- = 1.0 PEG 10% EPS growth
A PEG of 1.0 suggests that a company is fairly valued. If the company in the above example only had a P/E of five but was expected to grow at 10% a year, it would have a PEG of 0.5 -- implying that it is selling for one half (50%) of its fair value. If the company had a P/E of 20 and expected growth of 10% a year, it would have a PEG of 2.0, worth double what it should be according to the assumption that the P/E should equal the EPS rate of growth.
While the PEG is most often used for growth companies, the YPEG is best suited for valuing larger, more-established ones. The YPEG uses the same assumptions as the PEG but looks at different numbers. As most earnings estimate services provide estimated 5-year growth rates, these are simply taken as an indication of the fair multiple for a company's stock going forward. Thus, if the current P/E is 10 but analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5 and the stock looks cheap according to this metric. As always, one must view the PEG and YPEG in the context of other measures of value and not consider them as magic money machines.
Although the PEG and YPEG are helpful, they both operate on the assumption that the P/E should equal the EPS rate of growth. Unfortunately, in the real world, this is not always the case. Thus, many simply look at estimated earnings and estimate what fair multiple someone might pay for the stock. For example, if XYZ Corp. has historically traded at about 10 times earnings and is currently down to 7 times earnings because it missed estimates one quarter, it would be reasonable to buy the stock with the expectation that it will return to its historic 10 times multiple if the missed quarter was only a short-term anomaly.
When you project fair multiples for a company based on forward earnings estimates, you start to make a heck of a lot of assumptions about what is going to happen in the future. Although one can do enough research to make the risk of being wrong as marginal as possible, it will always still exist. Should one of your assumptions turn out to be incorrect, the stock will probably not go where you expect it to go. That said, most of the other investors and companies out there are using this same approach, making their own assumptions as well, so, in the worst-case scenario, at least you won't be alone.
A modification to the multiple approach is to determine the relationship between the company's P/E and the average P/E of the S&P 500. If XYZ Corp. has historically traded at 150% of the S&P 500 and the S&P is currently at 10, many investors believe that XYZ Corp. should eventually hit a fair P/E of 15, assuming that nothing changes. This historical relationship requires some sophisticated databases and spreadsheets to figure out and is not widely used by individual investors, although many professional money managers often use this approach.
Transmitted March 3, 1997
|The Fool Ratio|
VALUATION: THE PRICE/SALES RATIO
Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Whether or not a company has made money in the last year, there are always revenues. Even companies that may be temporarily losing money, have earnings depressed due to short-term circumstances (like product development or higher taxes), or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price/sales ratio, often simply abbreviated PSR.
The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company XYZ Corp. has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million.
Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either.
Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt
The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization. Say XYZ Corp. had $200 million in sales over the last four quarters and currently has no long-term debt. The PSR would be:
(1,000,000 shares * $10/share) + $0 debt PSR = ------------------------------------------------------- = 0.5
The PSR is a measurement that companies often consider when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition, many simply expropriate it for the stock market and use it to value a company as an ongoing concern.
USES OF THE PSR
As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 in order to find value stocks that the market might currently be overlooking. This is the most common application of the PSR and is actually a pretty good indicator of value, according to the work that James O'Shaughnessey has done with S&P's CompuStat database.
The PSR is also a valuable tool to use when a company has not made money in the last year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's sales are being valued at a discount to its peers. If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers. There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings.
Another common use of the PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E in order to confirm value. If a company has a low P/E but a high PSR, it can warn an investor that there are potentially some one-time gains in the last four quarters that are pumping up earnings per share. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings.
Transmitted March 3, 1997
|Cash Flow-Based Valuation
CASH-FLOW (EBITDA) & NON-CASH CHARGES
Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA).
Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, CYBEROPTICS (Nasdaq: CYBE) enjoyed a 15% tax rate in 1996, but in 1997 that rate will more than double. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits.
As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength.
WHEN AND HOW TO USE CASH FLOW
Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies like TIME-WARNER (NYSE: TWX) and TELECOMMUNICATIONS INC. (Nasdaq: TCOMA) have reported negative earnings for years due to the huge capital expense of building their cable networks, even though their cash flow has actually grown. This is because huge depreciation and amortization charges have masked their ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well.
The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work.
In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. Some counsel selling companies when their cash flow multiple extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA.
Investors interested in going to the next level with EBITDA and looking at discounted cash flow or EVA are encouraged to check out the bookstore or the library. Since companies making acquisitions use these methods, it makes sense for investors to familiarize themselves with the logic behind them as this might enable a Foolish investor to spot a bargain before someone else.
Transmitted March 10, 1997
WHAT IS EQUITY?
Equity is a fancy way of referring to what is actually there. Whether it's tangible things like cash, current assets, working capital and shareholder's equity, or intangible qualities like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow.
Traditionally, investors who rely on buying companies with a substantial amount of equity to back up their value are a paranoid lot who are looking to be able to collect something in liquidation. However, as the TV-dominated mass-consumer age has helped intangibles like brand names create powerful moats around a core business, contemporary investors have begun to push the boundaries of equity by emphasizing qualities that have no tangible or concrete value, but are absolutely vital to the company as an ongoing concern.
THE BALANCE SHEET: CASH & WORKING CAPITAL
Like to buy a dollar of assets for a dollar in market value? Ben Graham did. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits -- cash can fund product development and strategic acquisitions and can pay high-caliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand.
Another measure of value is a company's current working capital relative to its market capitalization. Working capital is what is left after you subtract a company's current liabilities from its current assets. Working capital represents the funds that a company has ready access to for use in conducting its everyday business. If you buy a company for close to its working capital, you have essentially bought a dollar of assets for a dollar of stock price -- not a bad deal, either. Just as cash funds all sorts of good things, so does working capital.
SHAREHOLDER'S EQUITY & BOOK VALUE
Shareholder's equity is an accounting convention that includes a company's liquid assets like cash, hard assets like real estate, as well as retained earnings. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -- whether those assets are office buildings, desks, old T-shirts in inventory or replacement vacuum tubes for ENIAC systems.
Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. To calculate book value per share, take a company's shareholder's equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book ratio.
Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value is actually somewhat skeptically viewed in this day and age, since most companies have latitude in valuing their inventory, as well as inflation or deflation of real estate depending on what tax consequences the company is trying to avoid. However, with financial companies like banks, consumer loan concerns, brokerages and credit card companies, the book value is extremely relevant. For instance, in the banking industry, takeovers are often priced based on book value, with banks or savings & loans being taken over at multiples of between 1.7 to 2.0 times book value.
Another use of shareholder's equity is to determine return on equity, or ROE. Return on equity is a measure of how much in earnings a company generates in four quarters compared to its shareholder's equity. It is measured as a percentage. For instance, if XYZ Corp. made a million dollars in the past year and has a shareholder's equity of ten million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. COCA-COLA (NYSE: KO), for instance, does not require constant spending to upgrade equipment -- the syrup-making process does not regularly move ahead by technological leaps and bounds. In fact, high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. This is why a pharmaceutical company like MERCK (NYSE: MRK) can grow at 10% or so every year but consistently trade at 20 times earnings or more.
Brand is the most intangible element to a company, but quite possibly the one most important to a company's ability as an ongoing concern. If every single MCDONALD'S (NYSE: MCD) restaurant were to suddenly disappear tomorrow, the company could simply go out and get a few loans and be built back up into a world power within a few months. What is it about McDonald's that would allow it to do this? It is McDonald's presence in our collective minds -- the fact that nine out of ten people forced to name a fast food restaurant would name McDonald's without hesitating. The company has a well-known brand and this adds tremendous economic value despite the fact that it cannot be quantified.
Some investors are preoccupied by brands, particularly brands emerging in industries that have traditionally been without them. The genius of INTEL (Nasdaq: INTC) and MICROSOFT (Nasdaq: MSFT) is that they have built their company names into brands that give them an incredible edge over their competition. A brand is also transferable to other products -- the reason Microsoft can contemplate becoming a power in online banking, for instance, is because it already has incredible brand equity in applications and operating systems. It is as simple as Reese's Peanut Butter cups transferring their brand onto Reese's Pieces, creating a new product that requires minimum advertising to build up.
The real trick with brands, though, is that it takes at least competent management to unlock the value. If a brand is forced to suffer through incompetence, such as AMERICAN EXPRESS (NYSE: AXP) in the early 1990s or Coca-Cola in the early 1980s, then many can become skeptical about the value of the brand, leading them to doubt whether or not the brand value remains intact. The major buying opportunities for brands ironically comes when people stop believing in them for a few moments, forgetting that brands normally survive even the most difficult of short-term traumas.
Intangibles can also sometimes mean that a company's shares can trade at a premium to its growth rate. Thus a company with fat profit margins, a dominant market share, consistent estimate-beating performance or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Although intangibles are difficult to quantify, it does not mean that they do not have a tremendous power over a company's share price. The only problem with a company that has a lot of intangible assets is that one danger sign can make the premium completely disappear.
THE PIECEMEAL COMPANY
Finally, a company can sometimes be worth more divided up rather than all in one piece. This can happen because there is a hidden asset that most people are not aware of, like land purchased in the 1980s that has been kept on the books at cost despite dramatic appreciation of the land around it, or simply because a diversified company does not produce any synergies. SEARS (NYSE: S), DEAN WITTER DISCOVER (NYSE: DWD) and ALLSTATE (NYSE: ALL) are all worth a heck of a lot more broken apart as separate companies than they ever were when they were all together. Keeping an eye out for a company that can be broken into parts worth more than the whole makes sense, especially in this day and age when so many 1970s conglomerates are crumbling into their component parts.
-Randy Befumo (MF Templar)
Transmitted March 5, 1997
VALUATIONS BASED ON YIELD
A dividend yield is the percentage of a company's stock price that it pays out as dividends over the course of a year. For example, if a company pays $1.00 in dividends per quarter and it is trading at $100, it has a dividend yield of 4%. Four quarters of $1 is $4, and this divided by $100 is 4%.
Yield has a curious effect on a company. Many income-oriented investors start to pour into a company's stock when the yield hits a magical level. The historical performance of the Dow Dividend Approach supports the general conclusion buttressed by Jim O'Shaugnessey's work that shows that a portfolio made up of large capitalization, above-average yielding stocks outperforms the market over time.
Some, like Geraldine Weiss, actually invest in stocks based on what yield they should have. Weiss measures the average historical yield and counsels investing in a company's shares when the yield hits the edge of the undervalued band. For instance, if a company has historically yielded 2.5% and is currently paying $4 in dividends, the stock should trade in the $160 range. Anyone interested in learning more about Weiss's yield-oriented valuation approach should check out Dividends Don't Lie. The simplest way to take advantage of stocks that are undervalued based on their yield is to use the Dow Dividend Approach, which you can learn more about in the "Fool's School" area.
Transmitted March 10, 1997
Sometimes a company can be valued based on its subscribers or its customer accounts. Subscriber-based valuations are most common in media and communication companies that generate regular, monthly income -- like cellular, cable TV and online companies. Often, in a subscriber-based valuation, analysts will calculate the average revenues per subscriber over their lifetime and then figure the value for the entire company based on this approach. If AMERICA ONLINE (NYSE: AOL) has six million members and each sticks around, on average, for 30 months, spending an average of $20 a month, the company is worth 6 million times $20 times 30 or $3.6 billion. This sort of valuation is also used for cable TV companies and cellular phone companies. For instance, Continental Cablevision was bought out for $2000 a subscriber.
Another way a company can be valued on members is based on accounts. In the healthcare informatics industry, companies are routinely acquired based on the value of their existing accounts. These acquisitions often completely ignore the past earnings or revenues of the company, instead focusing on what additional revenue could be conceivably generated from these new accounts. Although member-based valuations seem rather confusing, their exact mechanics are unique to each industry. Studying the history of the last few major acquisitions can tell an inquisitive investor how the member model has worked in past mergers and can suggest how it might work in the future.
Transmitted March 10, 1997
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