How To Value Stocks & Businesses

Knowing if a share is expensive or cheap is a useful skill. We wouldn’t pay £350 for a TV when everywhere else it’s sold for £300, would we? Likewise, when we buy a house, we don’t just buy it without doing any research. We want to know what something is worth and we want to pay a fair price for it. Nobody wants to get ripped off – nor should they be if we know the important metrics to consider. Stocks are no different, and knowing what a company is worth and what we’re paying is crucial when it comes to understanding value. As Warren Buffet says: “price is what you pay, value is what you get”. If we want good value for our money we need to understand the basic valuation metrics and techniques so we can apply them to our shares.

Why Are Valuation Metrics Important?

Valuation metrics allow us to assess the value of a stock and work out whether we are paying a fair price. We can do this by using several metrics which will be covered in this walkthrough:

  • Earnings per share (EPS)
  • Price to Earnings ratio (commonly referred to as PE)
  • Forward PE
  • PE to Growth ratio (popularised by Peter Lynch and known as PEG)
  • Enterprise Value (EV)
  • Dividend Yield (DY)

What Is Earning Per Share?

Earnings per share, or EPS, is calculated by taking the net profit of a company and dividing it by the total amount of shares in issue.

Most people believe that the best way to check how a company is doing is to see how much profit it is making. This is a good start, but it is earnings per share, or EPS, that matters the most.

This is because we use earnings per share and not net profit to see how a business is doing because as shareholders we care about how much profit we are entitled to. To explain further, please consider this:

Aerotyne International makes a profit of £1,000,000 in Year 1. The business makes a profit of £1,500,000 in Year 2. Going into Year 3 the business is expected to make a total of £2,250,000.

On the other hand..

Solid Carburettor makes a profit of £1,000,000 in year 1. In Year 2 the business makes a profit of £1,250,000, and is forecast to make £1,400,000 in Year 3.

Which stock of the two businesses would you rather buy? Aerotyne International grew profit at 50% year-on-year, whereas Solid Carburettor grew at 25%  from Year 1 and then less than 10% from Year 2 to Year 3. Clearly, Aerotyne International is the better choice using the above information.

However, let’s dig a little deeper at Aerotyne International.

Aerotyne International achieved a net profit of £1,000,000 in Year 1 but the board did not expect to achieve any growth in Year 2. The board decided to acquire a business that would give them further growth. In Year 2 they bought Winchester Disk Drives which made £500,000 of profit. Aerotyne International had 100,000 shares in issue however they issued a further 100,000 shares to pay for Winchester Disk Drives in equity, creating further dilution.

Once the transaction was complete Aerotyne International realised that their acquisition was not as great as it had looked because they had not undergone proper due diligence, and Winchester Disk Drives was only forecast to breakeven in Year 3. They decided to properly do their due diligence this time and acquire Stratton Technologies, which was projected to and made £750,000 in profit in Year 3. To do this, Aerotyne International paid for Stratton Technologies in equity again, issuing another 200,000 shares bringing the total to 400,000 shares.

The key point to be aware of here is not the profit but the share count. Let’s see how Solid Carburettor grew their profit:

Solid Carburettor made a profit of £1,000,000 in Year 1, and did not acquire any businesses in Year 2. The business is able to fund itself and grow from existing cash flows and made net profit £1,250,000 in Year 2, and £1,400,000 in Year 3.

Solid Carburettor tarted with 100,000 shares and did not issue any more shares over the three years.

Now which business did you choose? If you are unsure, let’s look at how net profit and earnings per share changed in each year.

                               Aerotyne International                                                Solid Carburettor

Year 1                   £1,000,000 / 100,000 shares                                       £1,000,000 / 100,000 shares
                                = 1000p EPS                                                                        = 1000p EPS

Year 2                   £1,500,000 / 200,000 shares                                       £1,250,000 / 100,000 shares
                                = 750p EPS                                                                          = 1250p EPS

Year 3                   £1,750,000 / 400,000                                                      £1,400,000 / 100,000

                                = 437.5p EPS                                                                      = 1400p EPS

Aerotyne International looked far more appealing looking at the net profit, but actually Aerotyne’s shareholders have been earning less per share, with EPS down from 750p in Year 2 to 437.5p in Year 3! This is because Aerotyne International diluted its shareholders in order to purchase growth, whereas Solid Carburettor did not dilute their shareholders at all.

Dilution

Dilution occurs when a company issues more stock or uses other methods of dilutive financing like options or warrants.

Options are the right to buy (hence option – the owner of the option does not have to buy) at a certain price and usually have an expiry period. It is the generic term for this contract and someone who owns a stock can sell to somebody else an option to buy their stock with certain conditions. In the case of director options when these are exercised, the company issues more stock and the option expires.

Warrants work exactly the same way as director options and they tend to be given to investors to sweeten up a financing deal. Because more shares are issued this means our percentage ownership of the company goes down, like the concentrate of blackcurrant juice when we add water to the glass.

Why Do Companies Dilute Their Shareholders?

Companies can issue stock for many reasons: to acquire a business, to raise more cash (mostly for this), or to incentivise management.

When investing in small caps we must be aware that shareholder dilution can be a necessary evil; many of the companies that trade on the stock market are not profitable and so to continue operating they need to raise more cash. Stock raised in these equity issues is usually at a discount to the current price which makes it attractive for new investors but less appealing for current shareholders. This is because the lower the share price of the new shares that are being raised the less cash the company will receive, and so it is in current shareholders’ interests to have the price as high as possible to minimise dilution.

An Example Of Dilution

If we own two shares of £1 in a company that is worth £10, we own 20% of the company. However, if the company decides to raise £5 more in cash for equity and sells to another investor ten shares for 50p, we will own two shares of twenty (10% of equity – we have been diluted from 20% to 10%). If the company had managed to sell five shares for £1 then we would have two shares of fifteen (13.3% of equity) and yet the company would have raised the same amount of cash (£5). It is in the company’s best interests for current shareholders to raise new shares at a price as high as possible and minimise dilution.

Not all equity issues are bad but we should be wary of buying shares into a company that is not yet profitable. Unless they have more than enough cash on the balance sheet to reach profitability it is likely they will need to dilute. The best way to avoid dilution is to only buy shares in businesses that are profitable and cash generative.

Using EPS For Valuation Metrics

There are several ways to value shares and the most common valuation metrics will be covered here. Price to earnings ratio, or (PE ratio, sometimes PER), is the standard metric used to identify how many times earnings we are paying for a stock. Some investors look at how the market capitalisation has grown over time, but as we have seen in the dilution sector how a company can increase its market cap simply by raising more cash which is not always in shareholders’ best interests. It’s important that we use earnings per share as this factors in dilution and shows the real performance of the company. Earnings, earnings, earnings!

Price To Earnings Ratio (PE)

The Price to Earnings Ratio is calculated by taking a stock’s share price and dividing this by the earnings per share. PE ratio tells us what we are paying for the stock in terms of the company’s earnings per share.

If a stock is priced at 10p per share, and earnings are 1p per share, then the price to earnings (PE) ratio would be 10 (10p / 1p = 10). This by itself is not that helpful, as we only know that if all variables stay constant then it will take ten years for us to earn our money back by owning the stock.

PE In Practice

Generally, investment theory believes that the lower the PE then the cheaper the stock is. If a stock is trading on a PE multiple of 3, then it will take only three years for our investment to pay for itself via the company’s earnings. The problem is that variables do not stay constant, and cheap stocks are not always cheap. PE ratio is best used as part of a screening process, and never to be used alone in valuing a stock.

We know that with all variables constant a share that trades on a PE of 20 should be growing its earnings by 20%. But we know not everything is constant, and so do we really want to be paying 30x earnings (PE of 30) for a company only consistently growing its earnings by 10%? On the other hand, if we could find a company consistently growing EPS by 30% and we could buy it on a PE of 15 that could be an attractive candidate. Looking at historic PE ratios and earnings can help us identify traps and prevent us from overpaying. One common mistake of investors when using PE ratio is to get suckered into a single digit PE that is a value trap.

Value Traps

Let’s consider a stock that has 1,000 shares priced at 1000p, and the stock had earnings per share of 250p. That gives the stock a PE ratio of 4 and would make the company cheap if we only looked at PE ratio.

However, next year the share price has nearly halved to 600p and EPS has fallen 20% to 200p. The company is now even cheaper! It trades on a PE of 3. But is this the stock we would want to own? The company trades on a lower PE because the share price is falling faster than its profits.

Value traps like this are not uncommon in low PE stocks – and eventually when they become loss-making they won’t have a PE at all.

Forward PE

One of the pitfalls of PE is that they are based on historic numbers. Understanding a company’s past is helpful but we are not investing for the past – we are investing for the future! To do this, we must look at forward PE. This takes the company’s expected earnings per share for the following financial year, and divides it by the current share price.

Forward PE will usually be cheaper than current PE, but it gives us an idea of what the company is currently trading at given their expected future earnings.

Of course, expected future earnings are exactly that – expected – and companies may beat their market expectations or fail to meet them (commonly known as a profit warning when announced to the stock market).

PE To Growth Ratio (PEG)

The price/earnings to growth ratio, or PEG ratio, is calculated by taking a stock’s PE ratio and dividing this by its percentage growth rate in earnings. The PEG ratio is a valuation metric that looks at the company’s PE valuation against its growth rate.

Generally, the market values those companies with a higher PE because the company is expected to have a higher growth rate. Using PE alone would then mean that higher growth companies appear more overvalued compared to lower PE companies. The PEG ratio allows us to look at all companies, irrespective of their PE ratio, and analyse their valuations compared to their growth rates.

The PEG ratio was popularised by legendary investor Peter Lynch, who wrote in his 1989 book One Up on Wall Street:

“The P/E ratio of any company that is fairly priced will equal its growth rate”.

Peter Lynch, Magellan Fund Manager at Fidelity

This means that any company that is fairly valued will have a PEG ratio of 1. Anything less than 1 suggests that the company could be undervalued (though one should never use PEG alone when conducting a fundamental valuation), and a PEG ratio of above 1 could suggest that the valuation is frothy.

High PE Ratios

Private investors are often scared away from high PE ratios, and for good reason. Lofty earnings multiples can come crashing back down to earth once reality sets in. However, for the investor willing to take on more risk and pay premiums for high quality growth stocks, huge returns can be made.[1]

Very often, companies grow into their forward PEs and eventually, in hindsight, we realise that they were not expensive at all. They were just priced higher because of their growth rate. We wouldn’t pay the same price for a Fiat as we would a Ferrari. Be aware when buying high PE stocks that if the quality is substandard, you will be in for a nasty shock. Check what is under the hood, and kick the tyres.

Some of the best stocks on the market trade with lofty PE multiples, but not all high PE ratio stocks are the best stocks on the market. The difference is in the projected growth and quality of earnings. Not all profits are equal.

Enterprise Value

The Enterprise Value (EV) of a company is calculated by taking the market capitalisation of the company, adding the sum of its total debt, and subtracting its total cash. It is the total value that someone would actually be paying for the company if they were to buy it. When Woolworths went into administration in 2008 it was available for sale for £1. That was the market value of the company. However, the market value didn’t take into account all of its debt, which was the very reason Woolworths went bust! The enterprise value gives us a much more accurate valuation of the company than the market cap.

This metric takes into account the current financial situation of the company. This is important because if both Company A and Company B were valued with a market capitalisation of £100 million but Company A had £20 million of net cash on the balance sheet and Company B had £50 million of net debt on the balance sheet this significantly changes what a shareholder is getting when they buy stock. Company A would have an EV of £80 million against Company B’s £150 million. We calculate net cash and net debt by taking the company’s total cash and subtracting the total debt.

EBITDA/ EV ratio

This metric is helpful to compare companies within the same industry, but relatively useless (in my opinion) for comparing companies that operate in different sectors. EBITDA stands for earnings before interest, taxes, depreciation, and amortisation.[2]

Companies in different sectors will generally have different levels of depreciation and amortisation. For example, a technology company that has fixed costs and very few tangible assets will have very different levels of depreciation and amortisation to a company that works in mining support services and a lot of tangible assets such as trucks and diggers.

Dividend Yield

The dividend yield of a stock is calculated by taking the dividend per share and dividing it by the share price. This tells us what percent of the stock that we buy we will receive back that year in dividends, but be careful – it’s no good buying a stock because it has an 8% dividend yield if it is likely to fall 10%!

Double digit dividend yields are very often a sign that the market believes the dividend itself is unsustainable, which is why the share price has fallen so much. There have been examples where this was not the case of course but it is something to check when buying a stock with a high dividend for income. Income investors like to buy stocks with steady yields, steady business models, and steady cash flows.

If the stock price falls, this increases its dividend yield – therefore if income investors though a double digit yield was attractive and sustainable they would be buyers.


[1] Mark Minervini has written two excellent books on this; both books are summarised on my website.

[2] There is a quote from Warren Buffett on EBITDA, which is both funny and true: “References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?”

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