In the previous post I came up with a range of values for a real publicly traded company. I used a very simplified DCF calculation to come up with these values. Some DCF calculations can use a lot of variables such as revenue growth, gross and operating margins, returns on equity and many other complex metrics. Personally, I don’t think it needs to be that complicated, but if someone wants to use numerous variables that is their choice. The value of a business is simply the sum of all future cash flows discounted back to the present. As I explained, it’s impossible to come up with a perfectly precise number because we can’t predict the future, unless you are a fortune teller. In which case I would like to know which stock will perform the best over the next 25-30 years so I can sell everything I own and buy it. All kidding aside, I personally prefer a DCF valuation, but there are other methods that can work pretty well depending on the business and industry. One advantage to these other methods is that they don’t require trying to forecast future earnings the way a discounted cash flow analysis does. Most of the time an investor can come up with a fairly precise ratio.
The most commonly used is the price to earnings ratio, or PE ratio for short. It simply takes the price of a company and divides it by the prior year’s earnings, or sometimes it will use the earnings for the following year, known as the forward PE. For example, if a company earned one billion dollars and has a market capitalization of 20 billion dollars, it would have a PE ratio of 20. (20/1) On a per share basis, if there were two billion shares outstanding, that means each share would be worth $10 and the earnings per share would be $.50. PE ratios are a quick and simple way to value a business, but they have a few big flaws.
The first big flaw is the PE ratio doesn’t tell you anything about the quality of the business. In general higher quality businesses trade for higher multiples, so it’s hard to tell if a company is cheap just because it trades at 8x earnings. Perhaps the business is in decline and the stock currently looks cheap, but not if earnings fall by 90%. A business such as a steel manufacturer could have a PE ratio of 8 and be severely overvalued due to the business being at the peak of it’s earnings cycle. It’s not uncommon for steel companies to earn $4.00 per share one year and lose $3 per share the following year.
The second big flaw is that PE ratios can be influenced by one time credits or charges such as an asset sale or a lawsuit. Let’s say a business earns $200,000,000 in total for the year but that was due to selling a part of the business that year for $100,000,000. If the business is valued at $2,000,000,000 at the end of the year, the PE ratio would be 10. Many investors would look at the PE alone and decide the business is cheap. If you look at the actual core earning power of the business minus the asset sale, it would trade for a PE of 20. The opposite would apply if the company had a one time charge, the PE ratio for that year would be much higher than the PE ratio based on the actual earning power of the business. Bottom line, make sure the PE ratio of a company isn’t influenced by unusual charges or credits.
One other major flaw of PE ratios is they don’t tell you much about the stability of the business. I would much rather purchase a company that has little to no debt, a really strong market position, high returns on capital, and solid growth prospects for 30x earnings, than buy a highly leveraged company with a weak market position, low returns on capital and in a declining industry for 8x earnings. Over the long term, even paying a higher multiple for a fantastic business should work out well, provided the business stays fantastic. In the short term, sometimes buying a lower quality company on the cheap will provide higher returns than the more expensive high quality company. In my view, it’s much easier to build wealth owning the great companies. The highest quality companies tend to sell at higher PE ratios most of the time, but avoiding them because the PE is too high will prove to be a mistake for most investors.
Now that we have covered PE ratios and why they have several flaws, a great way to value a business besides DCF is to calculate the free cash flow yield. The way I like to do this is to take the company’s free cash flow for the previous year or the expected free cash flow for the current year, and divide it by the enterprise value of the company, which is usually different from the market capitalization. To get the enterprise value, take the company’s market cap and subtract any cash on the balance sheet, and add all short and long term debt, preferred shares and pension obligations, if applicable. For example, suppose company A has a market cap of 20 billion, cash on hand of 3 billion, no debt, preferred shares, or pension obligations. It would have an enterprise value of 17 billion. (20-3) Let’s say they earned 1.5 billion last year of free cash flow, giving them a free cash flow yield of 8.82%. (1.5/17) Suppose company B has the same market cap of 20 billion, but only 1 billion in cash, 4 billion in debt, and a 1 billion dollar pension obligation. Company B would have an enterprise value of 24 billion. (20-1+(4+1)). Company B also earned 1.5 billion in fcf last year, giving it a fcf yield of 6.25%. (1.5/24) Even though both companies would have the exact same fcf yield based on fcf/market cap of 7.5%, they have drastically different fcf yields based on enterprise value. Company A is not only much higher yielding, but much less risky due to the lack of debt. I hope that makes sense, but companies with strong balance sheets (lots of cash, little debt) are often cheaper than they appear when using the free cash flow yield based on enterprise value instead of market capitalization.
Now that the fcf yield has been calculated, the next thing to do is compare it to the risk free rate, which is widely considered to be the current yield on the 10 year U.S. Treasury Bond. Suppose the 10 year was yielding 2%, both of the above companies would be considered dirt cheap as long as the free cash flow was stable and could grow at least modestly. Alternatively, if the 10 year yielded 12% instead, both would be very unattractive as investments unless the companies were going to grow very fast. Even then, they would still make for a risky bet, given you could get a 12% return on capital risk free. How interest rates influence asset prices deserves a post of its own, but for now suffice to say always compare a potential investment to the risk free rate.
There are a few other valuation methods that I will touch upon briefly. Many finance professionals use EV/EBITDA to value a company. EBITDA stands for earnings before interest, taxes, depreciation and amortization. The problem with this method is that those are all real expenses! Much like the PE ratio EV/EBITDA doesn’t really tell the whole story and can be quite misleading. I personally pay no attention to it, but others will disagree.
Another popular method is the price/book ratio. Book value simply refers to the value on the balance sheet after subtracting all of a company’s liabilities from its’ assets. Sometimes a variation of book value is tangible book value where intangible assets and goodwill are also subtracted from the total assets. Book value is a good way to get a shorthand valuation of a bank or insurance company. Book value for pharmaceutical or technology companies is almost useless, due to those industries not needing a lot of assets to produce a lot of earnings. Bottom line, it doesn’t hurt to look at a company’s book value, but I wouldn’t use it to value a company.
Smaller potential high growth companies are often valued in their early years on the price to sales ratio. This can be a rough gauge to attempt to value a small growth company, but most are speculations due to them being near impossible to value in their early years. A few could be worth a ton based on their future cash flows, but of course the future cash flows are impossible to predict so price to sales can be an ok proxy for value. The problem with price to sales is that the ratio says nothing about profitability. A company can grow sales quickly but lose more and more money due to expenses growing out of control. Like some of the other methods, price to sales is just a shorthand guide to valuing a company.
One quick and really effective way to value a company is to look at the company’s current dividend yield and compare it to its historical dividend yield, if the company pays a dividend. For example, if a company is currently yielding 5% but it has historically yielded 2.5-3% its likely undervalued, provided that the dividend payout ratio is near the same as it has been historically. This method works best with stable blue chip companies. For example if company xyz pays a $3 per share dividend, earns $6 per share, and is currently trading at $60 per share (5% yield) while historically yielding around 3%, it may be a great deal provided earnings aren’t about to drop precipitously. However if the company was trading at $100 per share and decided to keep raising the dividend over the years while earnings stayed the same the dividend yield could approach 5% but the company would not likely be undervalued due to earnings stagnating. Higher than normal yield can be a sign of undervaluation, but more digging is needed.
I still like a DCF analysis the best for valuing a business, but these other methods can work well especially if used together. There is no one method that should be used every time, but often using several will give an investor a decent idea whether the business is under, over, or fairly valued. Valuing a business is tough, the more tools an investor has the better off they will be.