A company’s price-to-earnings ratio (P/E) is a useful performance measurement. But it may not be enough, particularly in difficult and volatile trading conditions.
Equally, should you apply the same valuation measures to every company in your portfolio, or is it necessary to make exceptions depending on the characteristics of a given company?
Before we can understand the concept of relative value, we must first be clear about what we mean by the simple equity market capitalisation value.
Assume that a public-listed company has 300,000,000 shares in issue, trading at a price of 500p. In this case, the simple market capitalisation value is £1.5bn.
300,000,000 x £5 = £1.5bn.
P/E is probably the most popular relative valuation metric in use. Taking the same example of the company above, with a £1.5bn stock market valuation, how do we find out the P/E? The answer is that it all depends on how much profit the company makes.
So, if we imagine the £1.5bn company has annual net profits of £200m, its P/E ratio would be:
£1,500,000,000/£200,000,000 = 7.5
The company in our example has a P/E ratio of 7.5, or as commonly stated 7.5 times – it is valued at 7.5 times its earnings.
As the term would imply, relative value measures are just that; to have any real meaning, such ratios need to be compared with a reference point such as a peer group average.
For instance, the company in our example could appear cheap if the average company in its sector is valued at 10 times.
One problem with P/E though is what can happen when the going gets tough for the companies in our portfolios. Even good-quality companies can experience short-term periods when earnings turn negative. When this happens, P/E can cease to become a useful measure, providing invalid results.
In these cases, analysts must resort to other ratios that can still provide meaningful results even in difficult times. One such popular alternative measure is P/S, or price to sales.
If the £1.5bn company has annual sales of £375m per annum, its P/S ratio would be:
£1,500,000,000/£375,000,000 = 4
As commonly stated, the company in this example is valued at four times its sales. For instance, the company could appear cheap if companies in its sector are valued at five times sales on average.
While this gets around the problem of valuing companies that are reporting losses at difficult times, it also lends itself well to valuing companies that have not yet achieved profitability because they are in their early stages of development.
Earnings depend on accountants
Another problem with the P/E ratio is that the denominator of the equation, earnings, is subject to many elements of management discretion. These might include:
- Amortisation (the process of repaying debt through scheduled payments)
- Depreciation (allocating the cost of tangible assets over their useful life)
In short, P/E should not be relied on in isolation, but rather should be used in conjunction with other measures.
While using P/S appears to address some of the issues related to earnings, it still relies on price, which can be extremely volatile in itself.
In addition, it hinges on being able to make a reliable comparison between companies with similar characteristics to be meaningful. During periods of market dislocation and heightened market volatility, this can become a formidable issue.
Analysts commonly favour cash-flow analysis as actual cash flows are generally more difficult for firms to manipulate than reported earnings figures. Looking at firms’ actual cash flows and the related underlying trends over time can enable analysts to better understand what’s going on in the business.
Valuing firms by discounting cash flows rests on the notion that the intrinsic value of a financial asset is the value of the future cash flows that it generates.
Cash flows received in the future are worth less than they are today, and need to be discounted using a discount rate that takes into account the time value of money and the level of risk involved.
A principal advantage of this compared with relative value measures is that it produces a valuation that is independent of where other firms with similar characteristics are currently valued.
It relies on the company’s specific cost of capital, or ‘weighted average cost of capital’, which is made up proportionally of the firm’s cost of debt and equity. This can also be thought of as the minimum return that investors expect for providing capital to the company.
To obtain a valuation known as the enterprise value (EV), we can take the estimated future cash flows and divide them by the company’s weighted average cost of capital. This enables us to gauge the present value of future cash flows for the firm.
EV is a much wider measure of company valuation compared with the simple market capitalisation value described at the beginning of this article, especially as it considers factors such as the debt held by firms.
It is therefore seen as a much better estimate of value in the event of a takeover, as compared with market capitalisation; an acquirer would need to take on the target firm’s debt but could add the target’s cash and liquid investments to its own cash pile.
EV is often thought of as a theoretical takeover price. It can be calculated most simply as:
- EV = market value of ordinary shares + market value of preference shares + market value of debt + minority interest - cash and investments
Preference shares entitle the holder to a fixed dividend. Minority interest refers to ownership in a company of less than 50% by an investor or another firm.
Valuation whatever the weather
Popular relative measures such as P/E can be useful in alerting us to possible valuation anomalies that we can exploit. However, they cannot be used in isolation.
When companies have very low P/E valuations relative to their peers and appear cheap, we need to fully understand why before we act.
If we rely on reported earnings figures, we also need to be able to verify the accounting assumptions that have been used.
Other valuation techniques such as discounted cash-flow analysis can often give us more insight into factors specific to the firm.
While alternative relative valuation techniques such as P/S can be much more appropriate for certain firms and environments than P/E, absolute valuation measures such as EV can help to give us a more complete picture.