B How To Value A Company By Its Earnings -Think Giant GIC

Funds and Finance
How To Value A Company
By Its Earnings
-Think Giant GIC
Robert MacKenzie
B
efore taking the plunge into investing in
the stock market, it’s a good to understand
something about how to assess the value of
a company. With an estimate of a company’s
value in hand you’ll have an idea of whether its shares
are over-valued, under-valued or maybe just right, hence
whether to buy, sell or to hold an investment
How can we know the value of a company? One way
among several is by calculating its “earnings power value,”
or EPV. This involves using math, but as Warren Buffett
often says, all that’s needed for successful investing is the
arithmetic and algebra that we learned in high school.
(See the sidebar below for a refresher.)
An easy way to understand the concept of earnings
power value as applied to a company is to compare it with
something familiar to most of us — a guaranteed investment certificate (GIC). A GIC involves a fixed amount
of capital and a fixed rate of interest which yields a fixed
value over a given time period.
Figure 1. Math Matters - A Quick Refresher
Brackets, besides signaling multiplication, are used to indicate that terms belong together and that whatever is
and brackets are handled in an expression, with multiplying and dividing being done before adding and subtracting.
and the values on either side would still be equal. This also holds for algebraic equations, where letters are used instead
formula employed by analysts to estimate the present value of a security by its earnings power value, allowing them to
consider its purchase or sale.
30 ❚ Canadian MoneySaver ❚ https://www.canadianmoneysaver.ca ❚ MAY 2013
The basic equation for a GIC is FV=PV+PV(r), where
FV is the future value of the investment in a year’s time;
PV is its present value, or what’s it’s worth at the moment; and r is the interest rate in decimal terms that
is prevailing at the time of purchase. [This equation is
also the “time value of money” formula FV=PV(1+r),
which I discussed at some length in a previous Canadian
MoneySaver article (February 2009).] The equation tells
us that a GIC’s future value in one year is equal to its
present value plus its present value times the interest rate.
For example, $1,000 at 5% would amount to $1,000 +
$1,000(0.05) or $1,050 one year into the future. That’s
not so hard, is it?
Figure 2.
formed into a formula that we can use for valuing
companies based on their earnings power value. FV is
the future value, PV is the present value and r is the
PV from both sides gives us FV-PV=PV+PV(r)-PV. The
PV and –PV on the right side cancel out, leaving FVPV=PV(r). By substituting Earnings for FV-PV, we get
Earnings=PV(r). Next, dividing both sides of the new
equation by r gives us Earnings/r=PV(r)/r, or Earnings/
r=PV. In other words, the present value equals earnings
divided by the interest rate. For our GIC, this means that
PV=$50/0.05 or $1,000.
The present value is what we seek when valuing a company. From what we just worked through, we know that
in order to find its value we first need to find two things:
its earnings and the interest rate involved. No matter its
size or complexity, if we have these two numbers we can
use our simple equation to discover the firm’s earnings
power value.
Figure 3.
Now for the tricky part, which shows the power of
math. Say that we did not know the present value of the
GIC investment, only its earnings of $50 and the interest rate of 0.05 (5%). Could we find out its PV and its
FV? This is very important calculation because when we
apply the GIC model to valuing a company, its PV will
be what we want to find.
In our example, the earnings on the GIC are $50, and
are equal to PV(r), or $1,000(0.05). Put another way, the
earnings are the difference between the GIC’s FV and its
PV, or Earnings=FV-PV (i.e., $1,050-$1,000=$50). This
is the same as saying that the earnings in interest, when
added to the starting, or present value, add up to the final,
or future value of the GIC in a year’s time.
Given that earnings equal FV-PV, we need only go
a little further to find PV. Because we are dealing with
the equation FV=PV+PV(r), in which one side is equal
to the other, we can subtract the same number from
each side of it and not affect the equality. Subtracting
So where do we find the earnings? I won’t go into
depth now since it is a subject that would take an article on its own, which will come later. (I never said that
security analysis was not a lot of work!). By way of a
simple overview, analysts usually make use of operating
earnings as opposed to gross earnings or net earnings.
Average annual operating earnings over a business cycle
of 7-10 years, adjusted to provide earnings before interest and taxes (EBIT), can provide fairly reliable data.
Adjusted income taxes are then deducted from these
“normalized” operating earnings, the result sometimes
being termed NOPLAT, or normalized operating profit
less adjusted taxes.
As for the interest rate, it is the rate that the company
is paying to acquire the capital needed for their operations. Because most companies raise capital by selling debt
(bonds) and equity (shares), the rate we need will be an
average rate that is adjusted, or weighted, according the
portions of debt and equity of the firm’s total financing.
A previous MoneySaver article of mine (February 2012)
introduced the concept of capital structure and how to
calculate it. It is only a small step further to employ capital
structure percentages to find the weighted average cost of
capital (WACC), which is the interest rate required for
our present value equation PV=Earnings/r.
Returning to the GIC analogy, let’s look at how a GIC
can be valued based on its earnings and the prevailing
Canadian MoneySaver ❚ https://www.canadianmoneysaver.ca ❚ MAY 2013 ❚ 31
interest rate. Assume that the earnings on a 1-year GIC
are $5,000 and that the going rate of interest for GICs is
4% (expressed in decimal form as 0.04) According to our
formula PV=Earnings/r, the value of the GIC would be
$5,000/0.04 or $125,000. The future value (FV) of the
GIC in one year would be $130,000, but we are buying
it today and not in the future. We want to know how
much to pay for it now.
Suppose someone was desperate for cash and offered
to sell you a $125,000 1-year, 4% GIC for less than its
face value. At this lower price it would be undervalued,
a bargain compared with other 4% GICs currently on
offer. By the same token, if we bought it for more than
$125,000 we would be over-paying and wasting our
money.
Like the person desperate for cash, the stock market
offers to buy and sell shares of companies at certain prices.
For any given company, by employing the equation
PV=Earnings/r, we can come up a value for the shares.
Assume that the company earns $500,000 after taxes
in one year and that its weighted average cost of capital
(WACC) is 4% (0.04). According to our formula the
value of the enterprise is $500,000/0.04 or $12,500,000.
This $12.5 million (M) value is based on the earnings
power value of the company.
Before deciding to buy or sell this company’s stock, we
have to calculate what the company’s share price should be
by dividing its EPV by the number of shares outstanding.
Assuming that our firm, valued at $12.5 million and with
no debt, had 10 million shares outstanding, the value per
share would be $12.5M/10M or $1.25. If someone was
desperate enough to offer so sell his or her shares for 75
cents each, that would be a buying opportunity indeed!
But you would not want to pay much over $1.25 unless
you had very good reasons to speculate on an impending
increase in share price.
Of course, there is a lot of research to be done in order
to arrive at the point at which the EPV formula becomes
reliable enough to use as a guide to investing. Compiling
the data to calculate a firm’s average annual earnings and
the cost of its capital can be demanding. And after this
quantitative work is done we need to rely on experience
and sober qualitative judgments to decide whether to
act on it. But if security analysis can help us to avoid big
investing losses and, from time to time, uncover opportunities for significant gain on our capital investments,
then it’s well worth it.
Robert MacKenzie, PhD, CFP, CIM, Financial Advisor,
Nepean, ON (613) 225-1500 or (888) 571-2444, robert.
[email protected]
MoneyTip
Sell in May..........? continued
this day is unlikely to be known by non-Brits so it
data but controlling for extreme outliers have
Popular media often refer to this market wisdom in
the month of May, claiming that in the six months
to come things will be different and the pattern will
and is only because some significantly big gains
extraordinarily single-event specific losses have
occurred in the summer.
egy around a six-month time frame. Buy some
good companies....and just enjoy your summer.
race of the British horse racing season, however
32 ❚ Canadian MoneySaver ❚ https://www.canadianmoneysaver.ca ❚ MAY 2013
SOURCES: CMS and various others