How To Value Companies, Pt 2

By Tony Boden | 17 August 2007

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Most* companies exist to earn money. So hence one of the key valuation metrics for companies is the earnings they will make. (Earnings is one measure of profit.)

Previously we indicated that the true valuation of a company is based on its future earnings into the infinite future. Thankfully the market takes a more realistic view on our ability to forecast future earnings, focusing generally on earnings in the previous year, the current year, and next year too.

The most used measure is the PE Ratio, which is the market value of the company (as indicated by the share price) divided by the annual earnings (historic or forecast).

Purists prefer to use "Earnings Yield", which is the inverse (earnings divided by value). For example an earnings yield of 5% equates to a PE ratio of 20.

Earnings yield allows a tangible comparison with other measures. For example if we take an earnings yield of 5%, we can compare this with the interest rate you can make on an ordinary savings account.

The savings account is virtually risk free, whereas investment in the company carries a number of risks and opportunities. Primarily there is the risk that the company may make a loss or at least that the company may make less profit in the future. On the upside, there is the possibility company will grow its profits into the future.

So whilst the PE ratio (or Earnings Yield) provides an indication of whether a company's shares are cheap or expensive it is not the answer in itself, because one must consider the risks and opportunities facing the company.

For example a high PE ratio (low earnings yield) may be justified if the company faces limited risks and significant opportunities to grow earnings. Equally a low PE ratio (high earnings yield) may not indicate that a company is unjustifiably 'cheap' if there are significant risks to its future earnings.

To some extent, this judgement applied to what is an appropriate PE ratio squares the circle between the short term PE ratio and the idea of forecasting future profits out to infinity.

Another often used valuation metric is the Dividend Yield -- reflecting the current or future dividend divided by the current market price.

This is a very useful measure but I think for slightly different reasons than some investors imagine.

Many investors seem to obsess about the idea that the company is giving cash back to its shareholders. The act of a company paying a dividend shouldn't make its shareholders richer in any real sense. If a company's share price is 100p and it has "free" cash of 5p per share; the underlying company is valued at 95p and the cash at 5p. If this company then pays a dividend of 5p to shareholders, it will give up this 5p of cash and the shares will, at least in theory, trade at 95p. So the shareholder has 'gained' 5p in cash and lost 5p in shareprice.

In my view, the real value in the dividend yield metric is subtly different. Companies hate reducing dividends because the market puts so much store by them. So by declaring a dividend and particularly increasing it over the previous year the company is giving a fairly clear indication that it believes its earnings to be sustainable.

So, in my mind, the true value of the dividend yield measure is that it provides insight into the quality and sustainability of earnings. Of course there are potentially many more things to consider when looking at the quality and sustainability of earnings but starting with the PE ratio and dividend yield, gives a good first indication of a company's value in relation to its earnings.

* Some 'asset' type companies (eg some Mining, Oil or Investment companies) rather than make continual profits from trading operations exist to make significant gains through 'development' of their assets. Because there are likely not to be profits year in year out - earnings based valuation metrics are not appropriate.

More: How To Value Companies | How To Value Companies Part 3 | P/E And PEG Ratios | How To Profit From Shares