Your Guide to Valuing a Company — Part One

Your Guide to Valuing a Company — Part One

I’ve spent many years denying that I needed to specifically write to women.

Trotting out the same reason; ‘Money has no gender, therefore I don’t need to target just one section of the population.’

Over the past year, I’ve discovered this outlook wasn’t good enough. More and more women are investing, and they are looking for information anywhere they can find it. The difference is, they aren’t as visible as male investors.

It was a shock to discover that at least 30% of the audience at our Great Repression conference in Port Douglas last year was female.

This was in contrast to the 10 or so women in the 400-strong audience for our World War D conference in 2014.

At first I — and perhaps some of my co-workers — just assumed they might be the better halves of other attendees.

Once I started talking to some of the women in the audience, I discovered most of them were there because they were interested in their financial freedom. Not for their hubby.

The incredible female presence made me sit back and rethink how I reach out to female investors.

So, a few weeks ago I put a call out to hear from our female audience. As you can read here and here, I have been blown away by the response.

After sifting through the many emails women sent through, the biggest deterrents to investing for women were knowledge and industry jargon.

In every email, female investors wanted to learn as much as possible before taking the leap. Some women would spend thousands on a course to learn more about investing. Other women would take years reading about the stock market before buying shares.

That, and they found the gobbledegook from those in the markets useless.

However the key thing is, many female investors want to know the basics when it comes to deciding what company they should buy shares in. Many beginners didn’t even know where to start.

Over the next few weeks, I’m going to cover the basics of fundamental investing, qualitative analysis and technical analysis. All of these methods have their place. Some people like to combine a mixture of all three. Other investors tend to only stick to one. The important thing is to educate yourself, work out what you’re comfortable with, and go from there.

Like I said, it will just be the basics, but it should give you enough confidence to help you make a decision.

Today, I’m going to tackle fundamental analysis.

Fundamental analysis if a fancy-pants industry term to describe how you determine the ‘intrinsic value’ of a company.

In other words, what the business is actually worth, as opposed to what it trades for on the stock market.

Using this approach, you are using the company’s earnings to assess the real value of the firm.

This is a good place to start.

However, before you start to crunch the numbers, make sure you understand how the company makes money.

If you can’t understand the business model, step away from the stock.

Quite frankly it shouldn’t be that hard for a business to explain its revenue stream. Another way of looking at it is, if you can’t break down how the company earns money in 10 words or less, walk away.

Leave those sorts of speculative plays for investors that love rollercoaster rides.

Once you’ve got your head around how the company makes money, start with the dividend yield.

That is, the percentage return you will receive as income from owning the shares.

If you’re a medium to long term investor, you may want to consider opting in for a company’s dividend reinvestment plan (DRP). These are useful for gradually increasing your position in stock without spending more cash. Instead of receiving a dividend each year, you sign up for the DRP, and the total value of your dividend is converted into new shares.

Should you decide you’d rather receive the dividend as income, take a look at the yield before buying shares.

The formula is quite simple. You take the total annual dividend and divide it by the stock price, then times it by 100 to put it in percentage terms.

Let’s take BHP for example.

The full year 2016 dividend was 40.4 cents, and the share price is $24.87. So 40.4 divide by 24.87 = 0.0162. Times that figure by 100 and you have a current yield of 1.62%.

Simple, right?

What you need to remember is that this figure constantly changes based on the share price and the dividend paid each year. The prior year BHP had a yield of 3.4%. Often when a company cuts a dividend, analysts talk about investors ‘fleeing to higher yielding companies’. This means people looking for companies that are paying a more solid dividend.

Remember that if you’re looking a company that pays a reliable dividend each year, look at the historical dividend payments. Slowly increasing dividends each year are a good sign that the income will remain relatively stable.

Next up, is price to book ratio, or the P/B ratio.

The idea of the PB ratio is to calculate what the assets of the company are worth by using their book value. In theory, the book value is the cost of the assets minus liabilities, with the accounting genius that is depreciation or amortization applied. Generally speaking, the final book value should only include tangible assets.

Over the years, clever accounting practices have seen goodwill or intellectual property (intangible assets) creep in to valuation. Most of the time, a book value will note if it does incredible intangible assets.

There’s a reason why you need to know about the book value of a company. Book value is the sum of all the company’s assets, and the P/B ratio uses this information to give you an idea what the company would get for their assets if they went bankrupt immediately.

Don’t worry, you don’t need to work out the book value yourself. Most of that information can be found for free on sites like Yahoo Finance. In fact, your online broker may even have some of this information listed.

To calculate the P/B ratio is simple. You divide the closing price of the stock into the firm’s most recent quarter book value figure.

I’ll use BHP again. Monday’s closing price was $24.88, and the March 2017 quarter book value was 2.34.

As a formula, that looks like 24.88 divide by 2.34 = 10.6%.

For an infrastructure heavy company like BHP, the P/B ratio is a reasonable figure. Bank and tech stocks will have low P/B ratios, because they essentially don’t have any real assets.

What holds back the P/B ratio, is that it doesn’t tell you about the company’s debt level just by looking at it (remember how the book value figure is tangible assets minus liabilities?). However a debt-heavy company is likely to have low P/B ratio.

In fact, Warren Buffet reckons this is a useless way to determine the value of the company.

I disagree. The P/B ratio has a place. You’ll find it’s a useful tool to compare the asset backing of companies in the same sector.

More importantly, the 1993 Fama and French study highlighted that companies with a low P/B ratio tend to outperform firms with a high P/B ratio. That data is two decades old now, but research from Foye and Mramor in 2016 found the same applies today.

That’s enough to get you started. Next week I’ll explain how to calculate and use price to earnings ratio and price to earnings growth ratio.

They are nowhere near as complicated as some people in the industry would like you to think!

Shae Russell,
For Markets & Money

Shae Russell

Shae Russell

Drawing on her extensive experience, Shae is the lead editor of Markets & Money. Each day, Shae looks at broad macro trends developing around the world, combining them with her distaste for central banks and irrational love of all things bullion.

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