QUALIPORT
P/Es and Yields: A New Way

By Maynard Paton (TMFMayn)
February 8, 2001

Rochester, Kent – There are many ways to value a company. However, most private investors tend to stick to the traditional measures, the two most popular being the price to earnings (P/E) ratio and the dividend yield.

While tried-and-tested valuation tools remain effective, it always pays to think about possible improvements in their application. Can investors enhance their usage of the P/E and dividend yield? I think so. Here's how.

To begin with, we'll use the imaginary Company X. It has just reported earnings per share (EPS) of 20p and a dividend payout of 8p.

It's customary to use both the P/E and dividend measures to gain separate "fair values" for a company. For example, by applying a P/E of 20 to Company X, we get a share price of 400p (20*20p). However, by using a yield of 6%, we get a share price of 133p (8p/6%). But to me, it doesn't make sense to use each measure to generate separate valuations.

When applying a P/E to a company's earnings, you are effectively valuing each £1 of profit equally, even though part of that profit may be distributed as a dividend. To be precise, you are placing the same value on £1 of earnings that could be reinvested into a worthwhile business project as £1 of earnings that will soon be sitting in your bank account. Obviously, if the business project can create significant long-term returns, the £1 reinvested should have greater a value than the £1 paid out as a dividend. Yet the P/E does not make any distinction.

It's the same with the dividend yield, but worse. Here, you are effectively ignoring retained earnings. A company's retained profits obviously have some value (assuming they are to be reinvested with some care), yet the dividend yield implies the investor is only interested in today's payout level – not tomorrow's profits which could produce greater dividends.

Two-stage

To resolve these issues, it's best to use a two-stage valuation process. Simply incorporate both the P/E and dividend yield into a single valuation, but importantly, only value the appropriate part of a company's profits with the relevant measure.

Back to Company X. Using a dividend yield of 6%, we arrived at a "fair value" share price of 133p. This figure reflects the value of Company X if its dividends remain at the present 8p level in the future. The valuation also suggests all retained earnings are worthless.

But the 12p per share profit Company X has retained should hopefully create greater profits and dividends down the line. If we think a P/E of 20 is suitable for the retained earnings, then the value of those profits is 240p (20*12p).  Add the two valuations together and we get an overall share price of 373p (133p+240p).

P/E trap

So, how does all this affect the Qualiport and its valuation process? At the moment, I use a company's free cash flow yield for valuation purposes.

(A company's free cash flow yield has two main advantages over relying on accounting earnings and the P/E:

* Earnings are subjective and tend to overstate real "cash" profits, and;

* Calculating free cash flow involves studying a company's cash flow statement, which often highlights future trouble.)

However, to a certain extent, I've fallen into the trap outlined earlier for the P/E investor.

As we all know, company profits can be volatile. If you want a return on your money, you have two general choices. Either invest risk-free (deposit accounts, gilts and the like) or take on the extra risk of business.

Thus, if the yield from risk-free sources is 5%, the prudent Qualiport should demand at least 5% from an equity alternative. Conscious of a margin of safety then, let's say I seek an 8% yield on any investment. In other words, this means investing in suitable companies where the shareholder income (i.e. free cash flow) is 8% of the share price (in essence, I'm valuing a company's cash flows just like you would the coupons on a bond).

Dividends are different

However, a company's free cash flow funds its dividend payments as well as its future expansion. And there are two notable differences between retained cash and dividends that affect their value to the shareholder.

Firstly, dividends are dependable. If trading takes a nosedive, most companies, larger ones especially, will do their best to maintain their dividend (i.e. a certain level of profitability can be expected by shareholders). British Airways (LSE: BAY) is a good example.

And secondly, dividends are today's fact and not tomorrow's possibility. While reinvested cash may be put to good use by company management and may generate a return in the future, the individual shareholder has full control of the dividend in the here and now.

So given the greater reliability and reality of dividend payments, compared to the potential returns from the company's retained cash flow, it makes sense to be less demanding over a dividend's inherent value.

So, a two-stage Qualiport valuation process is required. Firstly, the retained cash flow should be valued at the original 8%. But the dividends should be valued at a lower rate, say 7%, given their less-risky nature. Of course, as dividends are not guaranteed, we still need to apply a rate greater than the risk-free level.

Process in action

So, using Qualiport watch list member Allied Domecq (LSE: ALLD) as a real-life example, we can see the two-stage valuation process in action.

Assuming 5% annual growth, Allied Domecq is expected to generate free cash flow of 27.1p per share this year. The prospective dividend payment is estimated to be 12p.

Thus, if I require a 7% yield on a 12p per share future stream of dividends, I'd pay 171p (12p/7%) for that part of Allied's profits. Then, if I required an 8% yield on the cash flow retained by Allied (15.1p per share), I'd pay 189p (15.1p/8%) for this more uncertain part of Allied's profits. Overall, with these circumstances, I'd only pay 360p (171p+189p) per share for Allied Domecq.

Summary

To summarise, it makes sense to value the "reality of dividends" separately from the "possibility of retained earnings". Used in isolation, traditional valuation tools such as the P/E and dividend yield do not make a distinction over how a company's profits are spent. The differing shareholders' risks that retained and distributed profits exhibit ought to be considered by all investors.

Fool buys Carpetright

Time and word count restrictions prevent me from giving the full details, but within the next five trading days, and according to the Fool's Trading Rules, the Qualiport will purchase £3,000 of Carpetright (LSE: CPR) shares. A full report will be published on Monday.

The author owns shares in Carpetright.