Valuing Stocks

**This is a guest post by Kelvin Seetoh, you can visit his website: https://Kelvestor.com if you like to read more of his article**

Value investing is one of the ways to compound your wealth. Starting out as an investor, the common valuation metric I use is price-to-earnings-ratio (PER). This is a very simple approach of taking the “share price divided by the earnings per share”. It can be calculated using “market capitalization divided by the net profit after tax”. It means the same thing.

Company ACompany A
Market Cap$100mShare Price$50
Net Profit After Tax$10mEarnings Per Share$5
P/E10xP/E10x

Using the above table, we assume that Company A has two million shares in the company. When the share price is $50, to find the entire market capitalisation of the business, we multiply the share price with the total number of shares. $50 x 2m = $100m. Likewise, to find the earnings per share of a company, you can take the net profit after tax divided by 2m which you will get $5 ($10m / 2m). It is all the same.

However, I realised that it may not provide me with the most accurate valuation of a company. It does not take in consideration the debt or cash position of the company. It could be a very fatal mistake to commit especially when you think you’ve found an undervalued company based on P/E.

Introduction of EV/EBIT

EV/EBIT is a slightly more advanced valuation method and I will do my best to explain. It can be very simple as well!

Enterprise Value divided by Earnings Before Interest, and Taxes (“EBIT”).

Why EBIT and not net profit after tax? In some companies, net profits could be distorted by exceptional items such as valuation gains of non-core activities, restructuring costs or impairments. You may not want to value a company based on non-recurring income! Let me share what is non-recurring income.

Company AFY2017FY2018Change
Reported Net Profit$10m$8m-20%
Minus: Disposal of Property$4m$0NA
Adjusted Net Profit$6m$8m+33.3%

Using Company A as an example, an ordinary investor would think that the company’s net profit has dropped from $10m in FY17 to $8m in FY18. However, looking deeper, company A sold a property for $4m in FY2017. We do not expect Company A to sell a property every year so we will consider it as non-recurring income.

The real underlying profit for FY2017 should be $6m ($10m – $4m). With better clarity, we know that the company A did better with $8m profit in FY2018. We are interested in the core earnings of the business.

Therefore, EBIT is a far better approach to assess the earnings accurately, excluding the factors of tax and finance expenses. EBIT is derived from deducting operating expenses from a company’s gross profits.

Here is Apple’s FY2017 income statement where I highlighted the operating income.

How to Value Stocks? – P/E or EV/EBIT?-How to Value Stocks? – P/E or EV/EBIT?

Why enterprise value, and not market capitalization? Imagine that a prospective buyer is keen to acquire the entire business from the stock market, does he pay the amount equivalent to the market capitalization of the business? The true answer is no. The prospective buyer takes on the debt or cash that comes along with the business. It may be higher or lower.

To determine the true value of the business, we need to use enterprise value.

Enterprise value = market capitalization + total debt – total cash and cash equivalent

Using 3 simple companies, assuming they earn the same amount of earnings, which company would you buy?

CompanyABC
Market Capitalisation$200m$200m$200m
Total Debt$0$50m$0
Total Cash$0$0$50m
Enterprise Value$200m$250m$150m

The answer is…. company C!

Using enterprise value as a guide, you can see that the true price tag for Company C is the lowest. When someone forks out $200 million for company C, he is paying out $150 million only! Why? By acquiring the company at $200 million, he gains access to a cash pile of $50 million. Therefore, the true price tag for the business is $150 million!

The calculation goes like this…. $200 million (market capitalization) + $0 (total debt) –  $50 million (total cash & cash equivalents)

To put things in better perspective,

Enterprise value = market capitalisation + total debt – total cash

EV / EBIT = enterprise value divided by EBIT

P/E = market capitalization over net profit after tax

CompanyFacebookFord
Market Capitalisation$561b$41b
Total Debt$0$154b
Total Cash$42b$26b
Enterprise Value$519b$169m
EBIT$20b$5b
Net Profit After Tax (NPAT)$16b$4b
P/E35x10.3x
EV/ EBIT25.6x33.8x

*the figures are not actual figures

You will see that, despite having a low P/E ratio, Ford’s share price had remained downtrend for the last 4 – 5 years. Why? An astute investor would investigate Ford’s debt and be worried. Taking its debt into consideration, EV/EBIT turned out to be 33.8x which is high!

How to Value Stocks? – P/E or EV/EBIT?-How to Value Stocks? – P/E or EV/EBIT?

(captured from Google Finance on 9 July 2018)

On the other side, Facebook has a P/E ratio of 35x yet its EV/EBIT 25.6x. For a high growth company like Facebook, the valuations are not too expensive.

Hope this article provides greater perspective. When the P/E is too high or too low, perhaps, consider using EV/EBIT to get a better assessment of the price-multiple!

Summary:

  • The Enterprise Value considers cash and debt amount to reveal a true price tag for a listed business.
  • The operating income (EBIT) removes effects from non-recurring items and different tax rates
  • The EV/ EBIT ratio provides more clarity compared to P/E ratio.

If you would like to receive more articles on our Investing 101, do subscribe to this website. You can also check out some of my past articles on REITs or get some investment ideas by browsing through my articles on companies analysis.

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