Valuation of Companies
– the difference between market value and book value
– techniques used to value companies
We know that the book value of the shares of a company is the value of the equity, which is the difference between the assets and the liabilities.
If you own just a few shares in a company, this figure does not tell you very much, so we can express it on a per share basis.
You can find this value, by using the following formula:
Book Value per share = Book Value / Number of Shares
Some companies are worth less than their book value but most are worth more.
1) It may simply be that the market value of one of the assets of the company is much higher then the book value.
The most common example of this is land and buildings. If you knew a company had an asset that was worth much more than it value in the books, you might be prepared to pay more than book value for the company so you could sell off the assets and earn a decent profit.
If they can pay more than the book value for the shares and still get a good return on their money, then it makes sense to do so.
Naturally, different investors and analysts have different opinions on what return is acceptable from a company and therefore arrive at different valuations. Bear in mind as well that the returns we can calculate from the accounts are what has happened in the past.
When we value a company, we are, implicitly or explicitly, predicting the future, which results in even greater variation in different people’s valuations.
Techniques vary from simple ones, which rely on the calculation of a single KPI, to extremely complex ones, which require quantitative analysis of risk and forecasting of a company’s performance for the next ten years.
Let’s explore a few simple techniques.
The more you pay for the shares, the lower your expected return so you buy shares up to a price at which the expected return falls to x percent.
This method is the approach used by the vast majority of analysts and investors, except that they turn the ratio upside down. Instead of dividing the profit by the value of the shares, they divide the value of the shares by the profit. This ratio thus becomes the price earnings ratio.
The price earning ratio would thus be:
P/E Ratio = Price / Earnings per share
= 500 / 46.3
What is the ratio measuring?
The ratio is measuring the number of years the company would have to earn those profits in order to get your money back. So after 10.8 years of earning 46.3 cents per share, the company would have earned 500 cents per share.
It is the P/E Ratio of a company divided by the growth in its earnings per share (EPS).
PEG = PE / EPS Growth
As with the PE itself, you can either use the prospective growth in EPS (which is uncertain) or the historic growth from the most recent annual report.
Companies tend not to pay out all of the year’s profits to their shareholders. Companies that are expanding rapidly needs cash to enable them to expand and then not to pay out much. They have low payout ratios.
Such companies are often valued using dividend yield. This is calculated as the dividends for the year divided by the market value of the shares.
We simply divide the market value of the shares by the book value, which gives us the market to book ratio.
Assume that someone is prepared to pay 500 cents per share of Company X and the book value is 285 cents. Hence we get the following:
Market to book ratio = Market Value / Book Value
= 500 / 285
If it seems low, then we would say that the market value should be higher. We might therefore decide to buy some shares.
If the ratio seems too high, we would take that as an indication to sell the shares.
Investors therefore face difficulty in comparing them.
The ratio is useful, however, when valuing companies whose business is just investing in assets. Such businesses include property investment companies and investment trusts.