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How to value shares

How to value a share is one of the most important skills in an investor's toolkit
November 27, 2019

It’s one of the most important questions when investing in shares: How much are they worth? Overpaying for shares is a key risk for long-term investors. What you pay can play a big part in what you get back in investment returns. Pay too much and you can end up with a very poor investment. Buying a share for less than it is worth can deliver handsome gains. Valuing shares is far from an exact science, but armed with some knowledge it is possible to make better and more profitable investment decisions.

I see a lot of things to do with investment as essentially being about the relationship between what is put in – investment or money – and what comes back as a result of it – profits. Value is no different. For me, you are looking to work out what something is worth relative to what you pay for it. So how do you work out the value of a share?

 

Valuation basics

Ask an investment professional to explain to you the value of a share and they are likely to say something along the lines of that it’s the value of all its future profits or cash flows discounted back to a value of money today.

What on earth does this mean in reality? The best way to explain this is to use an example of how most bonds are valued. Bonds are IOUs where the investor hands over money – usually in batches of £100 – to the borrower who in most cases (but not in a world of negative interest rates) promises to pay interest for a period of time – usually several years and then pay back the initial £100 borrowed.

Let’s say the government wants to borrow money for 10 years at an interest rate of 5 per cent. The cash flows for each £100 bond over the life of the bond are shown in the table.

 

The cash flow and value of a £100 bond paying 5 per cent interest

Year

Cash flow

Discount factor @ 5%

Present value (PV)

1

5

0.9524

4.76

2

5

0.9070

4.54

3

5

0.8638

4.32

4

5

0.8227

4.11

5

5

0.7835

3.92

6

5

0.7462

3.73

7

5

0.7107

3.55

8

5

0.6768

3.38

9

5

0.6446

3.22

10

105

0.6139

64.46

Total

150

 

100.00

Source: Investors Chronicle

 

Over 10 years, the investor receives back £150 – £50 in interest and £100 return of their money – for £100 invested. The value of the bond when it is issued has to take into account the fact that the investor has to wait to receive their £5 of annual interest and get their £100 back. This is all to do with something called the time value of money.

If someone offers you the option of having £5 today or £5 in a year’s time you should choose £5 today for two main reasons. Firstly, inflation will reduce the buying power of the £5. Secondly, it is possible to invest that £5 so that it is worth more in a year’s time. 

At an interest rate of 5 per cent, £5 would turn into £5.25 in one year’s time. This is the future value of £5 today. Alternatively you can say that £5 is the present value of £5.25 in one year’s time.

When valuing the bond, investors are discounting the future £5 interest payments and £100 return of principal to a present value – a value today – to reflect the time value of money and the fact that they are worth less today the longer they have to wait for it and the higher interest rates are.

Present values are calculated using discount factors. These are numbers that are applied to a future value to give a present value at a chosen interest rate. To calculate a discount rate you use the following formula:

1/(1+r)n where r is the rate of interest expressed as a decimal and n is the number of years you have to wait for your money.

So a discount factor for a cash flow received in one year’s time at an interest rate of 5 per cent is:

1/(1.05)1 = 0.9524. 

Applying this to £5 of interest gives a present value of £4.76. The discount factor for 5 per cent in nine years is 0.6446. The present value of £5 in nine years' time is £3.22. Again, just reinforcing what this means, if you had £3.22 today and invested it at 5 per cent for nine years you would have £5 in nine years' time.

If we add up all the present values of the future interest payments and the return of the initial £100 then we get a value for the bond of £100.

This is how many financial assets are valued. The approach is most suited to valuing bonds because the cash flows and the timing of them are known with absolute certainty in advance. The main reason for bond values changing is if interest rates change and with them the present value of future cash flows.

If interest rates fall, the present value of future cash flows goes up. This is because less is being given up today to get a given sum of money in the future. Higher interest rates reduce present values. 

 

Year

Cash flow

Discount factor @ 5%

Present value (PV)

DF @ 3%

PV

DF@10%

PV

1

5

0.9524

4.76

0.9709

4.85

0.9091

4.55

2

5

0.9070

4.54

0.9426

4.71

0.8264

4.13

3

5

0.8638

4.32

0.9151

4.58

0.7513

3.76

4

5

0.8227

4.11

0.8885

4.44

0.6830

3.42

5

5

0.7835

3.92

0.8626

4.31

0.6209

3.10

6

5

0.7462

3.73

0.8375

4.19

0.5645

2.82

7

5

0.7107

3.55

0.8131

4.07

0.5132

2.57

8

5

0.6768

3.38

0.7894

3.95

0.4665

2.33

9

5

0.6446

3.22

0.7664

3.83

0.4241

2.12

10

105

0.6139

64.46

0.7441

78.13

0.3855

40.48

Total

150

 

100.00

 

117.06

 

69.28

Source: Investors Chronicle

 

We can see what happens to the value of the same bond paying 5 per cent interest over 10 years at different interest rates. At 3 per cent, the sum of the discounted cash flows goes up to £117.06. At 10 per cent it falls to £69.28.

This shows you why interest rates matter so much when it comes to the valuation of financial assets and why so many people spend so much time trying to work out what direction they are heading. It explains a great deal as to why falling and low interest rates since 2009 have fuelled a bull market in bond and share valuations across many parts of the world.

 

Using discounted cash flow valuations (DCFs) to value shares

Many professional investors use the same DCF approach used to value bonds to try to value shares. The two main differences are that with shares, the future cash flows or dividends are unknown and also tend to last a lot longer than 10 years.

The other thing to bear in mind is that the interest rate used to calculate the discount factor to value shares is different. As shares tend to be riskier than bonds, investors usually demand a higher, additional interest rate to compensate them for taking on the risk – known as an equity risk premium. 

What this interest rate should be is one of the most debated topics in academic finance and I am not going to get into it here. A rough rule of thumb is that a rate of around 8 per cent is typically used by many professional investors to value the equity of a business.

Many analysts build very detailed spreadsheet models to forecast the future profits, free cash flows and dividends that are then used to try to value shares. The big issue with this approach is what happens after the model runs out. Analysts cannot forecast forever, but companies do tend to survive longer than the five and 10 years they forecast. They get around this by applying what is known as a terminal value – an estimate of what the value of the business might be after the explicit forecast period.

 

DCF valuation of Fevertree Drinks

Year

EPS (p)

Growth

DF @8%

Present value

1

62.2

 

0.9259

57.6

2

69.8

12%

0.8573

59.8

3

78.2

12%

0.7938

62.1

4

87.6

12%

0.7350

64.4

5

98.1

12%

0.6806

66.7

6

109.8

12%

0.6302

69.2

7

123.0

12%

0.5835

71.8

8

137.8

12%

0.5403

74.4

9

154.3

12%

0.5002

77.2

10

172.8

12%

0.4632

80.1

TV

3456

 

0.4632

1601.0

Value per share(p)

   

2284

Sources: SharePad, Investors Chronicle

 

Here, I’ve done a DCF valuation of Fevertree Drinks (FEVR). I've used earnings per share (EPS) as a proxy for free cash flow share and taken analysts’ consensus forecasts for the next two years. I’ve then assumed that EPS continues growing at the same rate of 12 per cent for the next eight years.

At the end of year 10, I have applied a terminal value that assumes Fevertree grows its EPS at 3 per cent forever. This gives a value of 3,456p a share in 10 years' time and is calculated using the following formula:

Terminal value = Cash flow/(r-g) where r is the discount rate and g is the long-term rate of growth.

172.8.(0.08-0.05) = 3456p.

Terminal values can be calculated in many different ways. If you wanted to keep things simple you could apply a multiple – a number – to the cash flow or earnings figure in year 10. In this case, applying a multiple of 20 would have given the same terminal value.

Based on the set of assumptions I have used and an 8 per cent discount rate, I am getting a valuation for Fevertree of 2,284p a share, which compares with a share price of 2,204p at the time of writing.

The key thing to be aware of when using DCF valuation approaches is that they are based on estimates of what will happen in the future, which will almost certainly be wrong. The credibility of your valuation is only as good as the assumptions behind it.

That said, your assumptions in many respects do not matter. For me, the real value to investors in using this form of valuation is not really in trying to work out what a share is exactly worth, but rather the expectations that are baked into the current share price. Your job is to go and do some research on the company and work out if the expectations for future profits are too high or too low. Ideally, you want to be looking for shares where the expectations are too low, which would indicate that the shares could be undervalued.

 

Using multiples and yields to value shares

For years, investors have used multiples of profits, cash flows and assets as a way to weigh up the value of a share. By far the most commonly used multiple is the price/earnings (PE) ratio.

Others are based on enterprise valuations (the market capitalisation of the company plus its debts) compared with operating profits (often referred to as earnings before interest and tax, or Ebit) or earnings before interest, tax, depreciation and amortisation (Ebitda). I prefer to use enterprise valuation multiples as they are not distorted by a company’s debt levels and allow for fairer comparisons between companies.

In very simple terms, the ratio tells you how many years' earnings are in the current share price. The higher the PE multiple, the more highly valued the shares. The PE, like all multiple valuations, is essentially a shortcut of a DCF. The higher the multiple, the higher the expected rate of future growth. Again, ask yourself whether those expectations are achievable, can be beaten or are too high.

I’ve always found yields – profits, cash flows or dividends expressed as a percentage of the share price – to be a more informative and useful way of appraising the value of a share. Yields or interest rates can be compared with other investments such as savings accounts on bonds.

The big advantage offered by owning shares is that the yields can grow as profits grow. One of my favourite and simplest measures of value and investment return is the yield on cost and the impact that growth has on it. At the moment, Fevertree's earnings yield on cost is just 2.8 per cent. If it can grow its earnings by 12 per cent for the next 10 years, then its yield on cost will have increased to 7.8 per cent at the end of it based on the current 2,204p share price.

Anyone buying Fevertree shares at flotation in 2014 at 170p will be very happy if they are looking at their earnings yield on cost. It will be 36.6 per cent in 2020 if forecasts are met and over 100 per cent in 10 years' time if it keeps on growing profits at a rate of 12 per cent a year.

The very powerful point to get across here is that the price you pay for a share, along with the growth in future profits, determines what you get back from it. At the right price and with strong growth you can make fabulous returns on your investment. At too high a price and with disappointing future growth the end result is likely to be not as good.

 

Fevertree earnings yield on cost 

Share price (p)

2204

 

Year

EPS (p)

Yield on cost

1

62.2

2.8%

2

69.8

3.2%

3

78.2

3.5%

4

87.6

4.0%

5

98.1

4.4%

6

109.8

5.0%

7

123.0

5.6%

8

137.8

6.3%

9

154.3

7.0%

10

172.8

7.8%

Sources: SharePad, Investors Chronicle 

 

Pick the right business that is capable of consistently growing its profits and dividends at the right price and the yield on cost can grow to very impressive levels. Warren Buffett’s Berkshire Hathaway owned 400m shares in Coca-Cola (NYSE:KO) at the end of 2018. The company started buying the shares in 1988 and it has an average cost per share of $3.25. Coca-Cola paid an annual dividend per share of $1.56 in 2018, giving Berkshire a staggering dividend yield on cost of 48 per cent. This number neatly shows the power of long-term investing from long periods of earnings growth. The shares that cost Berkshire $3.25 now have a price of more than $53.

 

Asset values

Some types of businesses, such as banks and insurance, property and asset intensive companies such as pubs, are often valued on the basis of their assets as much as their profits.

Deep value investors often become interested in a company when its shares trade at a significant discount to its net asset value (NAV) or the value of its shareholders; equity (the same thing).

You need to be careful with this approach as a business often trades for less than its NAV because it is going through a period of difficulty. If things get better then buying the shares at a discount can pay off, but often things can go from bad to worse.

Calculating NAV per share is very easy to do. You take the value for NAV or shareholders’ equity from the latest company balance sheet and divide it by the number of shares in issue, which you will tend to find in the notes to the accounts. Some investors like to focus on only the tangible net assets. To get this figure just take the balance sheet amounts for goodwill and other intangible assets away from the NAV figure

Pub company Marston's (MARS) – it reports its full-year results this week – is a company I identified a few weeks ago as trading below its NAV. Its last balance sheet in March 2019 gave a NAV per share of 136.1p, according to SharePad. The current share price at the time of writing is 125p.

Marston's is a cheap share, but is it cheap for a reason? Unless assets have a viable alternative use – in Marston’s case pubs can be converted to properties in some cases – the assets are only worth as much as they can earn.

A quick sanity check on whether a company’s assets are worth their balance sheet values is to look at the profits they are making. The best way to do this is to calculate return on capital employed (ROCE) or return on equity (ROE) – see my detailed study of Marston’s accounts in September and October this year for how to do this. A ROCE (a pre-tax figure) of 10 per cent and a ROE of 8 per cent (post-tax) is a rough ballpark figure for beginning to think that a company’s balance sheet figures are realistic.

Marston's ROCE for 2018 was just over 6 per cent, which is a relatively poor result and suggests that its assets could be overvalued. Its trailing 12-month EPS to March 2019 was 13.7p, which equates to a ROE of just over 10 per cent on the NAV per share of 136.1p.

This ROE might suggest that the assets are fairly valued. However, caution is needed here because ROE can be juiced up if a company has lots of debt, which Marston's does. For this reason, I always prefer to look at ROCE, which is not distorted by debt when weighing up asset values.

 

Sum of the parts (SOTP) or break-up values

Many professional investors use a SOTP approach when a company has several different businesses. The reasoning here is that a business might be worth more if its businesses were sold off separately rather than staying together.

Marston's is a good business to do a SOTP valuation on. It has three distinct businesses that can be valued separately. You can get most of the information needed to do a SOTP from the segmental analysis of a business found in the notes to its annual accounts and the balance sheet.

My SOTP valuation estimate of Marston's is based on EV multiples of its trailing 12-months (TTM) operating profits to March 2019, which are not expected to be much different from its 2019 results, which will be reported this week. The multiples are based on those of similar quoted businesses or prices paid in recent acquisitions, which you can easily find by doing a bit of digging online.

 

Marston's SOTP (£m)

TTM operating profit

EV multiple

Reason

Enterprise value

Managed Pubs

90

12.7

Same as Mitchells & Butlers

1143

Taverns

86.8

11.3

Stonegate bid for Ei

981

Brewing

33.1

11

Charles Wells multiple in 2017

364

Group Services

-25.6

10

Assumed not to grow much

-256

Total EV

   

2232

Less:

    

Net borrowings

  

Balance sheet value

-1438.3

Pension Deficit

  

Balance sheet value

-23

Equity Value

   

771

Shares in issue (m)

   

660.4

Estimated value per share (p)

   

116.7

Source:Annual Report/Investors Chronicle

 

This suggests that Marston’s shares are probably fairly valued at their current share price of 125p.

 

Don’t become obsessed by valuation

One of the most important lessons I have learned as an investor is not to let high valuations put you off a share. A good business with an ability to grow over the long haul can deliver excellent results for patient investors. Don’t be too mean and stay away from businesses that could give you a very good return on your investment – a high yield on cost – if you have the temperament to own them for years.

Paying way over the odds is often a mistake, but paying a reasonably high valuation for high-quality businesses usually pays off if you give them enough time. The quality of the business and its ability to grow should always take precedence over its current valuation, but few shares are a buy at any price.