Sizing up a company

If you are a value shopper, you would know the exact price to pay for an air-conditioner or a diamond bracelet. However, how do you decide what is the right price to pay for a company's business or its stock?

That's where valuation comes in. Valuing a company is necessary to determine how much an acquirer may pay for buying out a business. It also helps to price shares in Initial Public Offers or to bargain-hunt in the stock markets. So how do analysts arrive at the ‘value' of a business?

You'll hear of many different multiples used to value companies in the stock market. Here is a brief explanation of a few absolute as well as relative valuation measures.

PE Multiple

Price-earnings or PE is the most commonly used multiple. But it may have several variants- current PE, trailing PE and so on.

The ‘plain vanilla' PE is computed by dividing the share price of the firm by its earnings per share. PE multiples usually take into account the current market prices of a company.

When it comes to the denominator - the per share earnings, one can use the company's earnings for the past twelve months (known as trailing EPS), estimated earnings for the next 12 months EPS (forward EPS) or the earnings for a future year (future EPS).

A higher PE ratio indicates that the market perceives the company's growth rate to be higher or its risks to be lower and its payout ratio too could be higher (alternatively the company's reinvestment needs are lower).

PEG ratio

The “Price Earnings Growth ratio” compares a company's PE multiple with its expected growth rate in profits.

It is computed by dividing the PE multiple of the company by its expected growth rate in EPS. Note that the number used for EPS should be the same in the calculation of both “PE multiple” and “G”. For instance, if Hero Honda expects a 10 per cent growth in its EPS this year and its current PE is 18.15, then its PEG would be 18.15/10 = 1.815 times. A PEG multiple of 1 is considered a rule-of-thumb measure of ‘fair value'.

PEGY Multiple

It is another variant of PE multiple. It is calculated by dividing the PE ratio of a company by the sum of its growth rate and dividend yield, the idea being that dividends also add to an investor's total return.

Here, dividend yield is computed by dividing the expected dividend payout of the company by the market price of the stock. PEGY is relatively better than PEG as it considers the differences between companies in growth rate in EPS as well as expected dividend yield.

For example, if TVS motor's growth rate is 8 per cent and its expected dividend yield is 7 per cent, if the stock's PE is 18.65, then the PEGY for TVS Motors is 18.65 / (8+7) = 1.24 times while its PEG is 18.65/8 = 2.33 times. If a company's PE multiple is lower than the sum of its growth rate in EPS and expected dividend yield, then the company is undervalued.

Relative PE

The PE ratio or PEG may help you evaluate if a stock appears expensive or cheap relative to its profits or growth rates, but how do you decide which stock within the market or a sector is a good buy?

One relative valuation measure is to divide a company's PE multiple by the PE ratio of the market.

For example, the PE ratio for Nifty (this is available from the website www.nse-india.com) as on 24-12-2010 was around 24.

The relative PE for Bajaj Auto was 17.80/24 = 0.74 times. We can state that Bajaj Auto is undervalued compared to the Nifty or the market. While using relative valuations here, it is also necessary to take into account the company's historic premium or discount to the markets. For example, if Bajaj Auto has historically traded at 90 per cent of the market PE, it is now undervalued.

The above variants of PE ratio measure the market value of a company's shares by comparing it to its earnings. But these multiples do not value the entire firm. This drawback is addressed by the following measures.

Value to Earnings Multiple

It is arrived at by dividing the value of the entire firm by either its pre-tax profits (earnings before interest and taxes or EBIT) or its post-tax profits from operations, operating earnings.

What is the value of the firm here? It is the “Enterprise Value”, calculated as (Market value of Equity +Market Value of Debt – Cash). Higher the number, higher is the valuation the market is assigning to the company.

Value to EBITDA multiple

A small variation of the above, this measure uses EBITDA (Earnings before interest, tax, depreciation and amortization); this is especially applicable to loss-making companies. Some investors may want to value a company before considering the impact of financial leverage and depreciation on its earnings.

It is also possible that some companies may operate in industries with a longer gestation period. In all these situations, one can not arrive at the appropriate value for a company by employing the value to earnings multiple.

Investors able to estimate the future cash flows of a firm also employ a measure called value-to-free cash flow, which examines cash flows to a firm instead of its book profits.

So what is the ideal measure of value? Maybe a combination of the above. Apart from ascertaining the value of a firm using earnings multiples, one should also measure using traditional methods such as discounted cash flow to arrive at the correct value of business.

Each of the above multiples is suitable for a particular situation and no two multiples act as substitutes. After all, the valuation lies in the minds of the valuer.

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