Summary of Basis of Valuation and Methodologies used in Equity Sales Notes

Price to earnings ratio (P/E)

The P/E ratio divide’s the stock’s share price by its earnings per share in attempt to demonstrate how much investors are willing to pay for each pound of a company’s earnings. Logic would dictate that an investor is better off buying a stock with a lower P/E ratio than one with a high ratio, as they are getting more earning for their money. A higher P/E ratio should therefore reflect greater expected future gains because of the perceived growth opportunities but it can also indicate that the share price is relatively more expensive. Although often a useful valuation comparison tool, the P/E ratio does have its limitations. For example, the P/E ratio does not really work as a valuation metric when comparing companies across different industries because the amount an investor is willing to pay for earnings from one sector to another can differ significantly. On top of this, during periods when markets are out of equilibrium (e.g. the tech bubble of 1999), high P/E ratios may also reflect over-optimism and over-pricing and very low P/E ratios can demonstrate over-pessimism. It is also important to differentiate between historical P/E ratios and forecasted P/E ratios based on expected earnings. The latter is more commonly used by investors in attempt to effectively value a company’s share price.

Price to Book ratio (P/B)

The P/B ratio divide’s a stock’s share price by its book value (net assets, less any intangibles such as goodwill) in an attempt to illustrate what an investor is willing to pay for each pound of a company’s assets. Removing the intangibles allows investors to value the business on its ‘real-world’ tangible assets and excludes the harder-to-value intangibles. As such, the P/B is seen as a relatively conservative metric but it can also be quite misleading. For example, companies with a significant amount intangible assets (e.g. technology companies), the P/B ratio can be misleadingly high. As a result, P/B is often used for valuing financial stocks like banks and pension providers.

Free Cash Flow (FCF)

The FCF is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow represents the cash that a company is able to generate after laying out the capital required to maintain or expand is asset base. Some investors argue that this metric is more difficult to ‘cloud’ the free cash flow figure through accounting methodology. It is important to note that negative free cash flow is not necessarily a bad thing in itself as it can be a sign that a company is making large capital investments. Free Cash Flow Yield (FCFY) is calculated by taking the free cash flow per share and dividing it by the share price.

Enterprise Value by EBITDA (EV/EBITDA)

EV/EBITDA equals a company’s enterprise value divided by earning before tax, depreciation, and amortization (EBITDA). Enterprise Value is a measure which attempt to reflect the market value of a business using the market captialisation, adding debt, minority interests and preferred shares; minus total cash and cash equivalents. Potential acquirers of a business like to use this metric as it takes debt into account and strips out cash. As a result, a low ratio might indicate that a company is undervalued. Again, this metric does not compare well across different industries with higher multiples expected for high growth industries and lower multiples for slower growth sectors.

Net Asset Value (NAV)
NAV is the value of an entity’s assets minus the value of its liabilities. This metric is useful for valuing shares in sectors where the company value comes from the held assets rather than a steaming of earnings and/or profit that has been generated. Examples of these include property companies and investment companies/trusts. Investors use the share price to evaluate whether a stock is trading at a discount or premium to NAV. The NAV is calculated for most companies but can have little or no importance in industries where there is little investment in assets (e.g. asset light industries such as technology).

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