During bull markets you could be forgiven for thinking that the valuation of shares doesn’t matter. History tells us that over the long haul it does. The initial valuation that you pay for a share has a big influence on the returns you will get from owning it, and so being able to get some kind of feel for how a share is valued is very important.
Investors use a variety of measures to weigh up the value of companies and their shares. None of them are perfect, but I think it’s fair to say that some are better than others. In this article, I will take you through some of the most commonly used measures of valuation and the pros and cons of using them.
Why valuation matters
The valuation of a business (or a share of it) contains valuable information for the investor. In very simple terms, high valuations imply high expectations about a company’s future prospects; low valuations imply the opposite.
One of the keys to successful investing is to buy shares when you think the expectations baked into its share price are too low and sell when they are too high. To do this, you need a reliable yardstick of a company’s valuation.
The price/earnings (PE) ratio
By far the most common valuation measure is the PE ratio. Its key attraction is that it is initially very easy to calculate. You take a company’s share price and divide it by its earnings per share (EPS). This allows the investor to see how many times a company’s profits are reflected in the current share price. The higher the PE ratio, the more expensive a company’s shares are seen to be.
High PE shares are often more risky, but they can still be good investments if a company’s profits grow by more than people expect. The risk comes when profits disappoint. When this happens a company’s share price can fall heavily and investors can lose a lot of money.
The justification for buying low PE ratio shares is that expectations for future profits are too pessimistic. This can mean that the risk of losing money might be low, with the potential upside of making money if things turn out better than the market expects. This is the essence of value investing. That said, many low PE shares actually lose money for investors because the businesses behind them continue to struggle and see their profits continue to fall. These are commonly known as value traps.
Despite their simplicity, PE ratios contain many pitfalls for the unwary investor.
Apart from the question as to whether EPS is a good measure of company performance (I don’t think it is), the most obvious flaw is that PEs cannot be used when EPS is zero or negative. There are also issues with the fact that EPS can be subject to manipulation via the aggressive use of accruals (or matching) accounting. Then there is the fact that PEs are distorted by the use of gearing or leverage and large cash balances. I’ll have more to say on this shortly.
One of the big issues with using PEs is that investors are bombarded with so many different EPS numbers that it makes it difficult to know which one to use:
- Basic or reported EPS – which shows the profits and losses from trading activities as well as one-off gains and losses and expenses.
- Underlying, normalised or core EPS – the profits coming from the ongoing or continuing operations of a company.
- Diluted EPS – a measure that takes into account the extra shares that could be issued from share options, warrants and convertible securities.
- Trailing 12 month (TTM) EPS – the profits from the last year’s trading performance.
- Forecast EPS – the forecast profits of a company. In most cases, these forecasts are for underlying or normalised EPS.
- Rolling EPS – this takes into account the profits for the next 12 months and will contain a portion of profits that have already been made and a proportion of future forecast profits.
Depending on which EPS number you use, you will get a different PE ratio. For Tesco (TSCO), the range is between 13.3 times and 18.0 times, which could make the difference between interpreting whether the shares are cheap or expensive.
Tesco EPS and PE ratios
Share price (p) | 218 | |
EPS (p) | PE | |
Reported | 14.8 | 14.7 |
Underlying | 12.12 | 18.0 |
Diluted underlying | 12.08 | 18.0 |
TTM | 12.9 | 16.9 |
Forecast | 13.8 | 15.8 |
Rolling 1-year forecast | 16.4 | 13.3 |
Source: Company report/SharePad
Generally speaking, most investors will focus on the underlying profits of a company and take into account the diluted number of shares in issue. So they will look at PEs based on diluted underlying, normalised or core EPS.
This is the same EPS that companies tend to talk about in their communications with investors. You need to be wary of this number. Some companies can develop a habit of saying some costs are one-off or exceptional when they are not in order to make their underlying EPS look better.
You should always compare reported EPS with underlying or normalised EPS for a number of years. If there are big differences between the two numbers over a period of time you need to try to find out why this is happening. It can be a sign of aggressive accounting if normalised EPS is much higher than basic EPS. Staying away from these types of companies is a good way of protecting your portfolio from nasty surprises.
Forecast EPS is often used to make a PE ratio look cheaper for a growing business. There are also problems when comparing forecast PEs of different companies if they have different year-ends. Looking at a company in January 2019 with a March year-end means that the forecast PE is based on profits for a period that ends in just under three months’ time. Comparing the PE with a similar company with a December year-end does not make sense. Rolling forecast EPS and PEs are the way to get around this issue.
Other problems come with comparing companies with different tax rates or with companies that have abnormally low or high tax rates that distort EPS and also the PE.
Arguably the most significant problem with PEs is related to how a company is financed. Debt makes companies look cheaper on a PE basis. Let me explain why this is the case.
Let’s say you live in a town with two petrol stations called Petrol Pump and Oil Tanker. Both businesses are profitable and make £100,000 of trading profits a year and have been recently valued at £1m.
Despite having identical profits, the businesses are financed differently. Petrol Pump is heavily indebted with borrowings of £800,000, while Oil Tanker is debt-free. The value of equity in Petrol Pump is £200,000 (its asset value less its borrowings) and £1m for Oil Tanker.
Petrol pump | Oil tanker | |
Asset value = A | £1,000,000 | £1,000,000 |
Less Borrowings | £800,000 | £0 |
Equity value = B | £200,000 | £1,000,000 |
Trading profit | £100,000 | £100,000 |
Interest on borrowings at 5% | (£40,000) | £0 |
Profit before tax | £60,000 | £100,000 |
Tax at 20% | (£12,000) | (£20,000) |
Profit after tax = c | £48,000 | £80,000 |
P/e ratio = B/C | 4.2x | 12.5x |
Looking at the businesses on a PE basis which compares their equity values with their post-tax profits, Petrol Pump has a PE of 4.2 times and Oil Tanker has a PE of 12.5 times. But is Petrol Pump really cheaper than Oil Tanker given it has identical trading profits?
The answer is that it should not be and is not. It is the debt (or leverage) that has led to a reduction in equity value by 80 per cent compared with being debt-free, while post-tax profits have only fallen by 40 per cent (due to the interest expenses). This is why the PE has fallen even though the asset value for both companies is exactly the same.
The table below shows a selection of UK quoted companies with lots of debt as measured by debt to enterprise value trading on low TTM PE ratios.
Companies with Low PE and lots of debt
Company | TTM PE | TTM Debt to EV |
AA | 4.1 | 86.6 |
Brown (N) | 4.4 | 63.7 |
Countrywide | 1.8 | 70.3 |
Dignity | 5.8 | 63.9 |
KAZ Minerals | 5.5 | 78.7 |
Low & Bonar | 4.3 | 89.7 |
McColl's Retail | 3.2 | 85.2 |
Petrofac | 6.2 | 60.9 |
Premier Foods | 4.3 | 65.5 |
Source: SharePad
What investors should do instead – the case for enterprise valuations
There is no perfect valuation measure, but investors arguably need something to get rid of the distortions caused by debt and to some extent taxes, which can cause some problems when using PE ratios. The solution is to use enterprise valuations (EVs) instead.
EV is the market value of a business as a whole and can be seen as the market value of a company’s assets. EV is calculated by taking a company’s market capitalisation and adding to it the latest outstanding net borrowings (you would take away any net cash balance) and pension deficit (which is a debt in all but name).
Once you have calculated a company’s EV you can then use it to work out some useful valuation ratios based on it such as:
- EV/Ebit (earnings before interest and tax)
- EV/Ebitda (earnings before interest, tax,depreciation and amortisation) less capex
- EV/Nopat (net operating profit after tax)
- EV/FCFF (free cash flow to the firm)
The important thing to grasp with EV valuations is to match the numerator – the EV – with a measure of profit or cash flow that accrues to the business as a whole. This means that they will be calculated before interest on borrowings is deducted, but will include some expense for maintaining a company’s assets (depreciation or capex). This rules out the very popular EV/Ebitda measure as it makes no deduction for capital expenditures. Companies cannot survive for long without keeping their productive assets in good condition and valuing a company excluding an allowance for this does not make sense in my view.
The EV measures have been calculated for Tesco in the table below.
Tesco (£m) | ||
Share price (p) | 218 | |
Shares in issue (m) | 9,793.5 | |
Mkt cap (£m) | 21,350 | |
Net debt (£m) | 3,126 | |
Pension deficit (£m) | 2,574 | |
EV (£m) | 27,050 | |
TTM | EV multiple | |
Ebit (£m) | 1,638 | 16.5 |
Ebitda-capex (£m) | 1,296 | 20.9 |
Nopat (£m) | 1,253 | 21.6 |
FCFF (£m) | 1,496 | 18.1 |
Source: Company Reports
EV/Ebit (Ebit is a company’s operating profit plus any profits from joint ventures or associates) is discussed at length in Joel Greenblatt’s investment classic The Little Book that beats the Market. Ebit is a profit that accrues to the business as a whole to pay lenders and shareholders. It includes a provision for maintaining assets as depreciation, but is before tax and so cannot be distorted by it.
EV/Ebit takes into account leverage and stops you interpreting a low PE but highly indebted business as being cheaper than an identical one that is debt-free.
Petrol Pump against Oil Tanker
Petrol Pump | Oil Tanker | |
Asset value or EV = A | £1,000,000 | £1,000,000 |
Less Borrowings | £800,000 | £0 |
Equity value = B | £200,000 | £1,000,000 |
Trading profit (EBIT) =C | £100,000 | £100,000 |
Interest on borrowings at 5% | -£40,000 | £0 |
Profit before tax | £60,000 | £100,000 |
Tax at 20% | -£12,000 | -£20,000 |
Profit after tax = D | £48,000 | £80,000 |
P/e ratio = B/D | 4.2x | 12.5x |
EV/EBIT = A/C | 10x | 10x |
If we return to our earlier example of Petrol Pump and Oil Tanker, EV/Ebit says that they have identical valuations which makes sense given their identical profits.
EV/Ebitda less capex is an adjusted version of EV/Ebit that is sometimes used by professional investors if they think that the cash spent on new assets (capex) is a more prudent way of calculating the profits that can flow back to the business. Depreciation and amortisation is added back to Ebit to calculate Ebitda and the cash spent on tangible and intangible assets are taken away. Some companies give a figure for maintenance capex. If they do, then you can use that number instead if you wish to.
Nopat stands for net operating profit after tax. It is a company’s Ebit less tax. EV/Nopat can best be interpreted as a debt-adjusted PE ratio. Earlier we calculated Tesco’s TTM PE at 16.9 times. Its TTM EV/Nopat is 21.6 times – again showing how debts depress PE ratios and make a business look cheaper than it might actually be.
Free cash flow to the firm (FCFF) is the cash flow that flows to the business as a whole. You calculate it by starting with operating cash flow and then subtract tax paid and capex. EV/FCFF is a form of cash-based, debt-adjusted PE.
Regular readers of this column will know that I am a big fan of cash-flow-based measures to weigh up how good a company is and determining its value. Some caution is needed, though, as free cash flows can be flattered by inflows from working capital. Tesco tends to generate working capital inflows by delaying the payment of its suppliers. These supply costs are still a cost and should not be seen as a source of profits just because they have not been paid. FCFF can also be significantly influenced by whether capex is less or more than depreciation (which is deducted to calculate Ebit).
Tesco’s FCFF is greater than its Nopat (its comparable profit measure) due to working capital inflows and that cash taxes paid are lower than the tax expense in the income statement. Capex is higher than depreciation and amortisation.
Should investors pay for leverage?
One of the key takeaways from EVs is in showing how debt has the potential to mislead investors. It is counter-intuitive to think that companies should be cheaper because they have debts. The low PE ratio should be interpreted as a sign of increased financial risk, with the lower valuation being required to compensate investors for it.
Leverage can work in investors’ favour when trading is on the up, but I don’t see any reason why they should pay for it. Using EVs can stop you from doing so.
