As an entrepreneur, you probably appreciate how difficult it can be to get your business profitable. Once you have started earning money, you have to protect and grow your wealth in case the market goes south. This means you have to invest wisely.
One of the best ways to grow the wealth you earned from your business is by investing in the stock market. The average ROI of the Australian stock exchange over the last 40 years has been 11.49%. You can grow more by using the right stock valuation models.
What is the benefit of using these models? You will be able to find undervalued stocks.
The stock valuation methods that are most commonly used fall into the following categories. You will be a better stock investor if you learn and apply them.
These valuation models determine the value of the company based on its balance sheet. Therefore, this is a static valuation, which only considers the company’s situation at a specific and determined moment in time.
Methods based on discounted cash flows
Investors calculate the company’s value as the net present value of its future cash flows. The cash flow measures the cash generated by the company; it is calculated from the company’s net profit, adding depreciation and provisions and subtracting working capital requirements (also called “operating cash requirements”) and investment in fixed assets. Thus, this method focuses on the company’s potential to generate resources.
Methods based on stock market ratios
The technique values a company by looking for other similar companies (sector, size, etc.) listed on the stock exchange, applying the same ratios and comparing them. This is a great way to calculate a stock value based on its future earnings. The ratio par excellence is the PER (Price per share/Earnings per share), although there are others commonly used such as:
- Dividend yield: Dividend per share / Price per share.
- Price/Book value: This ratio compares the company’s market value with its book value, i.e., it indicates the proportion in which the market values the book value of the company.
- ROE (Return on Equity or financial profitability): measures the company’s capacity to generate profits with shareholders’ equity (capital stock + reserves).
- ROE = Profit / Shareholders’ Equity.
- Debt/EBITDA: This ratio indicates the company’s capacity to contract additional debt and refinance maturing debt. It is, therefore, a ratio that measures the relative level of financial leverage (debt contracted). EBITDA represents the gross operating profit or margin, i.e. earnings before interest, taxes and depreciation. This ratio tells us how many years it will take to pay off all the debt using the operating income.
Price-earnings ratio, the most common of the ratios used in stock market analysis, is defined as the quotient between the price per share and the earnings per share.
For example, the share price of a company, which has 100 million shares, is 30 euros per share; the company made a profit (net of tax) of 300 million euros in the last financial year.
The PER will be: 30/(300.000.000/100.000.000) = 30/3 = 10.
The PER provides different information. It reflects the multiple of earnings per share paid by the stock market, i.e. the number of times investors pay the annual profit of a company.
Investors can also interpret it as the number of years an investor will take to recover his investment (assuming that profits are maintained and fully distributed).
The inverse of the P/E ratio (1/PER) measures the return that the investor expects to obtain on the purchase of the share, assuming that the company’s earnings are not going to change in the coming years and that the entire profit is distributed as a dividend.
The P/E is usually calculated based on the previous year’s earnings and those expected for the current year. Thus, we usually talk about more expensive or cheaper companies depending on whether their P/E is higher or lower than those of other companies.
For example, the following data are known for a company at December 31 of year N: debt: $50,000; EBITDA: $70,000; annual result: $30,000; dividends: $10,000; share price: $80/share; number of shares outstanding: 1,000; unit book value of shares: 140; shareholders’ equity: $140,000. You will calculate the most common ratios with the above methods based on stock market ratios from the data shown above.
PER: price/earnings per share = 80/30 = 2.67.
Dividend yield: [dividend per share/share price] x 100 = [10/80] x 100 = 12.5%.
Price/book value: 80/140 = 0.57 (57%).
ROE (Return on Equity): earnings/equity = 30,000/140,000 = 0.21 (21%).
Debt/EBITDA: 50,000/70,000 = 0.71 (71%).
Regarding the use of this ratio, a potential investor will be interested in those companies whose P/E ratio is low compared to other similar companies or can be comparable due to their characteristics. In addition, the P/E ratio gives us an indication of the number of times the earnings per share are paid.
If we have a P/E of 10, this means that we pay a price for the share that is equivalent to 10 times the net earnings per share. Assuming that the earnings figure is maintained, we would need 10 years to recover the price paid for the share.
However, acquiring a stock with a high P/E does not mean that it is a bad investment, since if it is a company with good business prospects, its profit will foreseeably increase and its P/E will decrease over time.
In this sense, it is important not only to take into account the P/E at a given moment, but also its evolution over time.
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