Valuation of Companies

Valuation of Companies

In this lesson, you’re expected to learn:
– the difference between market value and book value
– techniques used to value companies
 So far we’ve talked about how to construct, interpret and analyse company accounts.

If you’re thinking about buying shares in a company, it’s important to know the difference between the book value and market value of shares.

Book Value

Book Value is simply the value that an item has on the balance sheet (i.e. ‘in the books’).

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 

Market Value

The balance sheet tells us what our shares are worth in the eyes of accountants. The fact is though, that we live in a market economy, where things are worth what someone will pay for them, not what anyone’s books say they are worth.

Some companies are worth less than their book value but most are worth more.

Why would anyone pay more than book value?

There are two possible reasons:

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.

2) In general though, people invest in a company because they believe it will provide a good return on the investment.

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.

Differing Valuations

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.

[Optional] The difference between book value and market value
There are many different techniques used to value companies. Unfortunately, since the value of a company depends on future events, none of these techniques is perfect. 

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.

1) Price Earnings Ratio (PER)

Using this method, you assess the company’s management, competition, markets, financial structure etc. such that you’re prepared to accept a return of x percent or more from the company.

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.

Suppose that the market value of each share of a company is 500 cents and the earnings per share is 46.3 cents.

The price earning ratio would thus be:

P/E Ratio = Price / Earnings per share
= 500 / 46.3
= 10.8

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.

2) PEG Ratio

Because the P/E of a company reflects its growth prospects, it makes sense to look at something that relates these two things to each other. This is what a PEG does.

It is the P/E Ratio of a company divided by the growth in its earnings per share (EPS). 

PEG = PE / EPS Growth

If the PEG is low, that suggests that you have found a company on a low PE relative to its growth rate. This may suggest that the company’s shares are undervalued.

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.

3) Dividend Yield

When you invest your money in a deposit account, the bank pays you all your interest.

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.

Other companies (such as utility companies) tend not to grow all that fast and thus are able to pay out a higher percentage of their year’s profits.

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.

4) Market to Book Ratio

This method compares the market value to the book value.

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
= 1.75

We could then compare this value with the market to book ratios of other companies and decide whether it seems reasonable or not.

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.

The problem with this method is that there is very large variation in these ratios in different industries and even within the same industry.

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.

[Optional] Methods of Company Valuation
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