Understanding Valuation Measures

Today we're going to switch a little from hard core analysis into a more basic analysis of stock statistics. Last week's article discussed business metric statistics, this week's article will focus on valuation statistics, and next week we'll look at financial health measures. While many likely will recognize these, and many already know them, this will give less experienced investors an idea of what these statistics mean, how to calculate them, and what is "good" or "bad".

First, let's take a moment to define what we're trying to measure. Valuation is a measure of how expensive a stock price is relative to the underlying business. There are several different attributes we can use to determine valuation. Just as you might judge the price of a car based on it's styling, engine power, features, and brand, you judge the price of a business based on it's earnings, net assets, cash flows, and revenues.

1) Price to Earnings Ratio (P/E)

What does it tell you?

How expensive a stock is relative to reported net profits. A higher P/E ratio indicates a more expensive stock relative to earnings.

How do you calculate it?

Stock Price / Earnings Per Share (trailing twelve months)

Forward P/E is used to determine what the P/E ratio should look like a year from now, based on earnings projections. This is useful if trailing earnings included sizable earnings gains or losses that were one-time in nature. It is calculated similarly:

Stock Price / Earnings Per Share (expected 1 year ahead)

What's good or bad?

The market at large has averaged about 15-17 P/E for much of the last 30 years. Some sectors average lower P/E ratios (like energy), and some average higher P/E ratios (like technology). As a rule, a P/E ratio under 10 is very low, and one over 30 is considered rather high.

Simple example

Johnson and Johnson (JNJ) earned a net profit of 3.63 per share of stock in 2007. The stock price today is 62.63. Therefore P/E is (62.63 / 3.63) = 17.24.

2) Price to Book Ratio (P/B)

What does it tell you?

"Book value" refers to the net worth of the company's property, buildings, equipment, cash, and other assets, minus bills outstanding, wages owed to employees, debt, and other liabilities. In essence, book value is what the company would be worth if liquidated. Most companies sell at a premium to book value because the company can generate profits from these assets.

How do you calculate it?

Stock Price / Book Value Per Share (most recent quarter)

What's good or bad?

Price to book is most useful for valuing companies where growth in assets is the goal of the business. Banks, insurance companies, and investment firms are good examples. It is a poor statistic for valuing companies where assets are primarily non-physical, like software and media companies. Benjamin Graham was a well known proponent of buying stocks under book value - although this is difficult to do today. A price-to-book value under 1.0 is really cheap, and under 2 is often considered a favorable valuation for asset based businesses.

Simple example

Johnson and Johnson's reported net equity (same as book value) was about $15 per share for 2007. Using a stock price of 62.63, this gives us a price to book ratio of (62.63 / 15) = 4.18.

3) Price to Sales Ratio (P/S)

What does it tell you?

Simply compares the stock price to the amount of sales per share the company has brought in over the last 12 months.

How do you calculate it?

Stock Price / Sales per Share (trailing twelve months)

What's good or bad?

The P/S ratio is highly correlative with net margin (discussed in last week's article). Higher net margin leads to a higher P/S ratio, because the company converts a higher percentage of sales to profits. The P/S ratio is considered less useful than the other valuation statistics by MagicDiligence. I recommend only using it to compare against other companies in the same business, or against historical averages of the stock being considered.

Simple example

Johnson and Johnson earned about $20.99 in sales per share of stock for 2007. Using the stock price of 62.63, this gives us a price to sales ratio of (62.63 / 20.99) = 2.96.

4) Price to Cash Flow (P/CF)

What does it tell you?

This ratio is very similar to P/E, except it uses the cash flow per share instead of earnings. This cuts out non-cash earnings and charges like depreciation and changes in working capital. This is a better measure of the actual dollars being generated by the business. Cash flow is generally what most people think of when doing their own finances.

How do you calculate it?

Stock Price / Cash Flow per Share (trailing twelve months)

Cash flow can be garnered from the Statement of Cash Flows, under Cash Provided By Operating Activities.

What's good or bad?

Studies have been published that show that companies with higher cash flow numbers than earnings are better performers over the long run. Compare P/CF with P/E and if it is a lower number, consider this a positive sign.

Simple example

Johnson and Johnson delivered 5.28 of cash flow per share in 2007, well over it's 3.63 of reported earnings. This is because the company accounted for depreciation of it's equipment, amortization of it's intangible assets, and other accounting tricks that allow the company to pay lower taxes. But the actual amount of cash the business raked in was significantly higher, giving a P/CF of (62.63 / 5.28) = 11.86, well under the P/E of 17.24. This is a positive sign the company may be undervalued, as Wall Street focuses on P/E to a much larger extent.

5) Price to Free Cash Flow (P/FCF)

What does it tell you?

Same as P/CF, except we subtract out cash needed to replace obsolete equipment and ongoing maintenance expenses. This is considered "free cash flow", that the company can use however it sees fit to reward shareholders. Examples of use of this free cash can be share buybacks, dividend payouts, or investment in growth opportunities.

How do you calculate it?

Free Cash Flow = Operating Cash Flow - Depreciation

This is a simple generalization - most textbooks will say to use Capital Expenditures instead of Depreciation. But MagicDiligence feels this is the best equation for the majority of stocks, as Capital Expenditures often includes growth based investments such as new stores or plants.

Price to Free Cash Flow = Stock Price / Free Cash Flow per Share (ttm)

What's good or bad?

Again, if a company can generate more free cash than it reports in earnings, this is the sign of a very well run business. Companies that generate free cash flow well under earnings generally require a lot of capital investment to sustain the business - an undesirable trait.

Simple example

From Johnson and Johnson's 5.28 of cash flow per share, we deduct 0.96 per share of depreciation expense, which is roughly equivalent to maintenance costs. This leaves us with a free cash flow per share of 4.32. Therefore P/FCF is (62.63 / 4.32) = 14.51. This is still well under the P/E of 17.24, a positive sign.

6) EBIT / Enterprise Value (Earnings Yield)

What does it tell you?

This is the second "golden statistic" of the Magic Formula. In effect, Earnings Yield is the inverse of P/E, but also subtracts out variables such as tax rate and investment income, while adding in the effects of debt. It tells you the percentage of earnings you are getting for each share of stock.

How do you calculate it?

EBIT stands for "earnings before interest and taxes". This is also known as operating earnings (see last week's article for details).

Enterprise value is simply market capitalization plus debt. It represents the price a suitor would have to pay to acquire all of the company.

Earnings yield is simply the quotient of these two statistics:

Earnings Yield = (Operating Earnings / Enterprise Value)

What's good or bad?
Joel Greenblatt decided to use this formula because it is a reliable measure of valuation between companies, regardless of industry. Because of this, a true "good" or "bad" value can be obtained. Look for over 9% earnings yield as the sign of a relatively cheap stock.

Simple example

Earnings yield is calculated more on an overall basis instead of on per share figures. Johnson and Johnson reported operating earnings of 13.7 billion for 2007. Currently, market cap is 181 billion and debt is 9.5 billion, leading to an enterprise value of 190 billion. Earnings yield is (13.7 / 190) = 0.0721, or 7.21%. This is not bad, but below what is required to make the Magic Formula screen.

Sourced from here

Free Cash Yield: The best valution statistic?

Valuation of stocks is a topic on which mountains of material has been written, and it has been discussed on the internet ad-nauseam. It's easy to see why - valuation is probably the single most important part of consistently picking winning investments. Get it right (or close to right), and you give yourself a great chance of significant gain with minimal risk. Get it wrong and... well, you know the rest!

In fundamental stock analysis, there are a number of valuation statistics, many of which have been discussed on this blog before. The most popular, of course, is the price-to-earnings ratio, or P/E. This ratio is easily calculated and can be found almost anywhere you can find a stock price. But is it really the single best valuation statistic to use to determine quickly whether a company may be undervalued?

First, the benefits. As mentioned, P/E is easily accessible. Second, it is a good point of comparison. If a stock's P/E ratio is lower than the overall market's, lower than it's primary competitors, and lower than the specific stock's historical average, the stock is likely to be undervalued and warrants additional inspection.

But there are drawbacks to the P/E ratio as well. First, P/E can be widely skewed by one time charges or benefits. For example, if a company sells off a portion of it's business, the gain on the sale is recorded as earnings, raising the "E" portion of the ratio and bringing the overall P/E down. If we don't dig deeper to ensure that the P/E ratio we're comparing against competitors, the market, and historical average represents an accurate number for the core business, we can be fooled into thinking it's undervalued.

Second, P/E includes charges and benefits not related to the core business. Non-operating income and charges such as interest paid on cash and investments, other investment gains and losses, income taxes, and other items are included in the P/E. Since these can vary considerably between companies, but have no bearing on how good or bad the business itself is, they can skew the ratio, making comparisons with competitors less than perfect.

Joel Greenblatt provides us with a similar, but better, statistic in The Little Book that Beats the Market: Earnings Yield. In essence, earnings yield simply flips the P/E ratio upside down, making the ratio into a percentage. For example, a 15 P/E becomes a 6.7% earnings yield. Turning P/E into a yield percentage is useful, because we can then compare it against bond or treasury yields. The current yield on a 10 year treasury is about 3.5%, so the stock would appear to give us 3.2% extra return for the risk involved.

But Mr. Greenblatt goes farther with his version of the earnings yield. For "E" portion in his version refers to operating earnings. Operating earnings are also known as EBIT - earnings before interest and taxes, which strips out the non-operating costs and revenue from the result, allowing for a more meaningful comparison between companies. The "P" portion refers to Enterprise Value. Enterprise value is simply market capitalization (the price the market has put on the company, or share price times number of shares), plus debt, minus cash on hand. By making these changes, Greenblatt incorporates balance sheet risk (or lack of) into his earnings yield calculation, while making it a better comparison between companies and against treasury and bond yields. Clearly, his version of earnings yield is a better metric than straight P/E.

One problem remains... earnings as reported is not always a tangible figure. A lot of assumptions are used by accountants to come up with earnings figures. First, they must decide what is actually a sale - some customers may never pay, and contracts can always be renegotiated or canceled, even after being reported as revenue in the income statement. Also, income statements include assumptions for such things as depreciation of property and equipment, the eventual value of stock options granted, and so forth.

This is why the cash flow statement exists. A company can use accounting tricks to fake earnings, but cold hard cash is harder to fake - the company either collected it or it didn't. What's more, the true value of a business is simply the discounted sum of all future cash flows, according to accepted finance theory. So, cash earned is clearly a better measure of business performance than earnings. Free cash flow is a step better, as it subtracts out the costs the company must pay to keep the business operating (such as equipment repairs, computer replacements, etc). MagicDiligence uses the depreciation figure to approximate these costs.

Once we have the free cash flow figure, we simply plug that in as the "E" portion of Greenblatt's earnings yield equation, and we have free cash flow yield. This is a powerful figure - it measures a company's cash generation, balance sheet risk, and share price all at once, and allows a meaningful comparison against both other stocks and fixed income assets like bonds and t-bills. No other valuation statistic gives you this much relevant information.

For those who are lost, I'll run through a simple example using my favorite lab rat - Johnson & Johnson (JNJ). To calculate earnings yield, here are the values you need from the 10-K. They've been gathered for this example:

* Net Cash from Operations (Cash Flow Statement)

* Depreciation and Amortization (Cash Flow Statement)

* Cash and Short-term Investments (Balance Sheet)

* Long-term Debt (Balance Sheet)

* Diluted Shares Outstanding (usually in the Income Statement, although sometimes you need to look in the footnotes).

* Current share price (Yahoo! or wherever)

The values from the last 10-K are (in millions):

* 15,249

* 2,777

* 9,315 (7,770 cash + 1,545 short-term investments)

* 7,074

* 2,910.70

* 64.88

First, we calculate free cash flow by subtracting depreciation from net cash earned:

* Free cash flow = (15,249 - 2,777) = 12,472

Next, we calculate enterprise value. First calculate market capitalization by multiplying share price by number of shares. Then add debt and subtract cash and short-term investments to that figure:

* Market Cap = (64.88 * 2910.70) = 189,000

* Enterprise Value = (189,000 + 7,074 - 9,315) = 186,759

Free cash yield is then FCF/EV, or:

* Free cash yield = 12,472 / 186,759 = 6.68%

This seems like a fair premium to the low treasury bill rate, for such a quality company. Stocks get into real bargain territory when free cash yield approaches 10% but remember, fundamental analysis is needed before putting your hard earned money into the stock.

Sourced from here