WM Morrison (MRW) and Auto Trader (AUTO) are two companies listed on the FTSE 100 index of the London Stock Market. Both are consumer facing companies servicing predominantly British customers. In this guide we will be using these two companies to paint a picture of company valuation.

WM Morrison - Founded in 1899 and headquartered in Bradford, Morrison's is one of the UK's biggest supermarket chains. Its market share has hovered around the 10 per cent mark for five years as it competes with larger British rivals Tesco, Asda and Sainsbury and the encroaching competition of the German discounters Aldi and Lidl. 

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Auto Trader - Publishing details of used cars for sale was a business model John Madejski brought back from the US in 1975. Two years later the company published its first print magazine - Hurst's Thames Valley Trader. Print publishing is no longer part of the Auto Trader business model which is now an online platform for buying and selling cars.

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Step 1: Determine company value

There are two main ways of determining company value.

I) Market Capitalisation

The value of a company is often thought of in terms of its share price and market capitalisation (the aggregate market value of shares in issue). However, this only represents  part of the picture and can be misleading for companies with high borrowings, high lease liabilities and pension deficits. 

So we also have...

II) Enterprise Value (EV) 

EV represents the market cap plus other claims on the company's assets and earnings which rank above the claims of shareholders. The most significant of such claims usually relates to a company's lenders - i.e. its net debt. Other major considerations are lease obligations and pension deficits.

In its most basic form:  EV = market cap + debt - cash

Top Tip: Enterprise value is extremely hard to calculate accurately because debt moves around during the course of a year and the figures investors get from the balance sheet only represent a period-end snapshot (usually period ends are chosen to present the most flattering possible picture of debt). Other potential components of the EV valuation require a company or investor to make assumptions to estimate the true size of the liability. 

Step 2: Valuation should not be taken in isolation

Share price, market capitalisation and enterprise value represent only a fraction of the picture of a company's valuation. To understand company valuation it must be compared with the company's underlying financial performance. Here are three things to value a company against.

I) Comparisons with profits

The most commonly used measures of profits for valuing shares are: 

Earnings per share (EPS) - profits per share after interest costs, minority interests and tax are taken

Earnings before interest and tax (Ebit) - as well as payment for debt, interest payments include some of the costs associated with pensions and leases 

Earnings before interest, tax, depreciation and amortisation (Ebitda) - profits before interest payments, and also depreciation and amortisation expenses (which are charges used to offset the benefits of assets used in a period with their historic cost)

Because Ebit and Ebitda are measures of profit before interest payments and before the deduction of minority interests (the proportion of a subsidiary's profit that belongs to a minority owner of the subsidiary) valuation comparisons need to be made with EV. But because EPS is profits per share after interest and minorities (and also tax), it needs to be compared with share price.

So we have:

EV/Ebit

EV/Ebita

P/EPS, known as a P/E ratio.

II) Comparisons with the source profits (Sales or NAV)

In most industries the source of a company's profits are its sales, but in some industries, like property and finance, it is its assets. Valuing against a company's source of potential profits is very useful if profits are currently low or nonexistent, but are expected to be much bigger at some point in the future (recovery plays or early-stage growth plays). 

Sales can be compared against either EV or share price. In the case of assets, share price is compared with net asset value per share (also referred to as book value or shareholder equity). So we have:

EV/Sales

P/Sales (alternatively referred to as price to sales ratio or PSR) 

P/NAV (alternatively referred to as price to book or P/BV or P/B)

III) Comparisons with cash flows 

Reported cash flow is more tangible and harder to manipulate than profits. However, cash flow statements are far from tamper-proof and cash flows can be very volatile, especially for companies which periodically have high investment needs (i.e. building a new factory). Acquisitions can also make cash flow much harder to interpret. Popular cash measures include operating cash flow (the amount of cash generated before investment, interest and tax) and free cash flow (the amount of cash generated after all necessary spending in the year). Two popular ratios are:

P/free cash flow (FCF) per share

EV/Operating cash flow

NB. All valuation ratios can be expressed as yields by flipping the equation on its head and multiplying by 100.

Step 3: Justifying a higher or lower valuation

Company value and valuation don’t mean a lot out of context. When deciding whether a company’s shares are worth buying and whether the price is right, valuation should be looked at in the context of the company’s operations and the wider market. Here are five ways of rationalising a company's valuation.

1. Balance sheet risk

Weak balance sheets put shareholder value at greater risk should trading deteriorate. It follows that companies with weak balance sheets (high liabilities, especially debt) should have lower valuations to compensate for this risk.

2. Cyclical risk

Companies with profits that are highly sensitive to their industry's business cycle have high cyclical risk and should have lower valuations to compensate for this. 

3. Operational risk

Companies with high fixed cost bases will have profits that are very sensitive to changes in sales (using industry jargon this is referred to as high operating gearing) and should have lower valuations to compensate for this risk.

4. Quality

A company should command a higher valuation if it is able to produce (a) a high return on money it invests in its business, (b) a high level of profit on the sales it makes, and (c) turn a high proportion of profit into cash. The consistency with which a company can do these things is also key.

5. Growth

The higher a company's growth rate, the higher the valuation should be to reflect the prospect of higher profits in the future. Useful ways to measure growth (both for sales and EPS) include:

Historical growth based on the compound average growth rate (CAGR)

Forecast growth (although future earnings are notoriously difficult to predict)

Forecast revisions (upgrades and downgrades)

A price/earnings growth (PEG) ratio can be used to assess what investors are being asked to pay for a share based on a multiple of its current earnings relative to growth in earnings. PEG = P/E ratio / EPS growth rate

(a crude rule of thumb is that a PEG of less than 1 is attractive)

A big growth caveat

Growth is more valuable the larger the difference between a company's return on invested capital (ROIC) and its cost of capital (often referred to as weighted average cost of capital or WACC). There is much debate about how cost of capital should be calculated, but it essentially boils down to a blend of company specific risk and the level of safe return investors could get as an alternative by buying long-term government bonds. If a company's cost of capital is higher than its return on capital, growth will actually destroy value because the extra cost from making the new investment to achieve growth will outweigh the return got. If this is the case, growth should actually reduce the valuation.

Discounted Cash Flow (DCF) models try to include all these factors (return on capital, growth and cost of capital). DCF models attempt to determine a valuation based on the present value of all future cash flows. The problem is there are so many assumptions that need to be made about the future to create a DCF model that this valuation method is often too clever for its own good. DCF is also open to serious manipulation in order to justify any given valuation.