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