| How to value shares ---part 1 |
 The year 1956 saw legendary investor Warren Buffet start his investment career with a paltry $105,000. Forty years later, Buffet has managed to turn that to over $40 billion! As an investor, your first question is likely to be HOW? How can it be possible to generate such phenomenal profits just by buying ordinary shares on the stock market? Ask Buffet and he is likely to talk about being a 'Value Investor.’ He says, 'The open secret to successful investing is to buy good quality companies that are trading at a steep discount to their value.’ Buffet and many other investors like him understand that the current price of any asset and its value can be significantly different and they exploit this difference to their advantage. This article aims at demonstrating how you too can effectively determine the value of a company's stock in order to reap large profits with well-calculated risks. The idea is to buy stocks when they are cheap and sell them when they are expensive. The difference between price and value! We can instinctively feel the difference between price and value. For example, when we hear that Tunde is financially distressed and needs to sell his car this week, we know that he is likely to accept a price that is well below its value. Deals like this are common in the stock market. The key to making money lies in your ability to determine the value accurately, so that you can identify the opportunity. Some members of financial establishments would have you believe that you need to be a banker, a stock analyst or a financial expert in order to value a stock. This is not true. Stock valuation can be done by most people, the only skills required are the ability to add, subtract, multiply and divide. One can learn how to value a stock within a day and as a result invest with a much higher level of financial success and confidence. This series of two articles aims to show you how to do so. What is a share? A 'share' is a small percentage (or part) of a company. When you buy a share, you buy a part of the cash flow and profits of the company. So the way to value a share is to value the company and then divide its value by the total number of shares issued by the company (this number will normally be published in the balance sheet section of the annual report - make sure you are looking at the most recent report, because the total number of shares in a company can change as a company issues new shares or buys back existing ones.) The two types of valuation There are many methods of valuation which analysts use to value the shares of an organisation. They fall into two categories (in fact, here at Smart Investor our analysts use both methods before advising you on what we believe is the fair value.); They are 'ratio based' and 'discounted cash flow' methods of valuation. In ratio based valuations you calculate certain financial ratios using numbers from the financial statements and compare them to the ratios of similar companies in the same industry. The commonly used ratios are: 1. Price to earnings ratio (PE) - Price/Earnings 2. Price to earnings growth ratio (PEG) - (Price/Earnings)/Growth rate 3. Enterprise value to Ebitda ratio (EV/EBITDA) 4. Price to Sales ratio - Price/Sales 5. Dividend yield - Dividend/Price 6. Price to Book Value (P/B) In Discounted Cash Flow valuations, you determine the current value of the cash that the company will generate in the future. The basis of the current value of cash is that any cash you receive today (or within this financial year) is worth more than cash you will receive next year or some years into the future. In the method, you forecast the likely profits and cash flow for a company over a period in the future and then you choose a discount factor (a measure of how much more a naira is worth today compared to next year) and discount the future cash flows and add them all up. Ratio based valuations We will start with 'ratio based valuations'; not only can they be calculated very quickly, they tend to be very popular with investors and analysts. You will see the financial press mention Price to Earnings ratio very frequently. Price to Earnings ( P/E) ratio is calculated by taking the current price of the stock (which you can get from a popular newspaper) and dividing it by the last reported earnings. For example, on 1 August 2006, First Bank was selling for N62.50. We also know First Bank reported earnings per share of N3.32k for the year ending 31 March 2006. So the P/E ratio is 6250k/332k (price per share in kobo/earnings per share in kobo) or 18.825. If you compare this to the P/E ratio for other banking stocks you can reach a point of view as to whether First Bank is cheap or expensive when compared to others. P/E method of valuation also highlights one of the weaknesses of ratio based valuations. It is quite possible that all the stocks within a certain industry are overvalued or undervalued. Some times, for various reasons, investors get optimistic or pessimistic about an industry or even the entire market. At the beginning of this decade many investors in Western markets were highly optimistic about Internet stocks and their demand drove up the price (and P/E ratios) of such stocks to very high levels. So, if you compared the P/E ratio of the Internet stock you were buying to other Internet stocks you would have found them reasonably priced. There can be other substantial reasons for a difference in P/E ratio between shares of different organisations. Growth rate is a major influence on the P/E ratio and if one company is growing at double the rate of others in the industry then it must be worth more, simply because the future profits will be much higher when compared to those of the slower growing organisations. This brings us to the PEG ratio. PEG Ratio PEG ratio has been created in an attempt to remove some of the weaknesses in the P/E ratio. PEG factors in the growth of a company into the ratio to give a more realistic valuation of the stock. The PEG ratio can be calculated by dividing the PE ratio by the current year's earnings growth. In the example of First Bank we have already calculated the PE ratio to be 18.825, we must also calculate the growth rate. A quick look at the financial statement shows that the earnings per share for the group were N3.29 in 2005 and N3.32 in 2006. First Bank also issued bonus shares and that needs to be accounted for in the growth percentage calculation. The true growth of the company was 17.8%. Based on this the PEG ratio is 18.825 / 17.8 = 1.06. As a thumb rule, a PEG ratio above 1 is perceived to be expensive and below 1 is considered to be cheap. Based on this assumption we can assume that First Bank’s current value is fair. EV/EBITDA Enterprise value over EBITDA is a common ratio used extensively amongst stock analysts and financial professionals. It is not commonly used by amateur investors as it takes a little longer to calculate than the P/E ratio. Let's start with Enterprise Value (EV). EV encompasses a simple concept. It is a measure of the total value of a company and represents the claims of the equity holders (owners of the shares) and debt holders (owners of the bonds and debt). It is calculated by adding the market capitalisation (share price multiplied by the number of shares) to the net debt (which is found in the balance sheet.) The net debt comprises of the total debt outstanding less the company’s cash. For example, imagine you purchased the entire company. Not only would you be buying all the cash of the company, but you would also be buying all the debts. Adding net debt to the market capitalisation results in EV, which is an accurate representation of the value of the company. A numerical example of WAPCo is illustrated below: Market capitalisation = 3 billion shares x N27 per share = N81 billion Net debt = N28.1billion (total debt) - N2.9 billion (cash) = N25.2 billion EV = N81 billion + N25.2 billion = N106.2 billion Thus the EV for WAPCo is N106.2 billion EBITDA simply means Earnings Before Interest Payments, Tax, Depreciation and Amortisation. Let's consider each account head individually. Interest payments are excluded as we have added back the debt when calculating the company's EV (if you own the entire company you could decide to increase the debt - thus increasing interest payments and reducing earnings or vice versa). Depreciation and amortisation are also excluded because these are non-cash entries in the Profit and Loss statement. Since no cash has changed hands, it does not make any difference to the company from a cash point of view. Subsequently, Tax is also excluded even though it is an obligation of the organisation and would need to be paid. In order to calculate EBITDA, you need to get the following figures from the company's Profit & Loss statement: Operating Profit, Depreciation and Amortisation. Add Depreciation and Amortisation to the Operating Profit and you get EBITDA. The formula for EBITDA is = Operating Profit + Depreciation + Amortisation The EBITDA for WAPCo would be: EBITDA = N6.1 billion (operating profit) + N1.5 billion depreciation = N7.6 billion The final calculation of EV/EBITDA is a simple division. The calculation of the EV/EBITDA of WAPCo is as follows: 106.2 / 7.6 = 13.9 With this figure we can compare WAPCo to its industry peers in a way that is not distorted by the different ways in which its peers might be financed (e.g. one of its peers may be financed mainly with debt, whilst another might have no debt at all.) Price to sales ratio (P/S) This ratio is simply the price of the shares divided by the total sales (sometimes referred to as the total revenue) of the company. P/S is useful if a company is not making a profit, or if profits have been badly hit due to a one off event or temporary situation, and it is expected that the company will get back to its normal footing at some point in the future. Again you would compare the P/S ratio that you have calculated with the P/S of similar types of companies, or even to historic P/S ratios for the same company. Dividend Yield Companies are likely to use their profits (or earnings) for two things; invest it back in the company in order to achieve growth (which if successful results in appreciation of the shares) or distribute it to its shareholders as dividends (or sometimes in the form of share buy backs). Companies differ enormously in their dividend policy and the percentage of earnings which they distribute as dividends. Thus, dividend yields are not always comparable even for companies in the same industry. The importance of the dividend yield is two fold: Firstly, it is important for investors who are investing in the company for a steady source of income. They need to know how much income they are likely to receive in the future. Secondly, since dividends represents actual cash that is distributed by the company, it is difficult to commit fraud or practice 'creative' accounting practices. The health of the company is directly proportionate to the increase or decrease in the levels of dividends. A high dividend rate is likely to demonstrate a confident management and a shrinking dividend rate might spell trouble for the company. The dividend yield of an organisation is calculated by dividing the dividend paid by the price of the share. The formula for this calculation is: |
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