The price is the result of a specific transaction related to a good or right, also in specific circumstances, being affected by certain exogenous factors and circumstances related to both the buyer and the seller.
However, the valuation of a company is fundamentally defined by the application to the business of certain assumptions, which are not necessarily those applicable in determining the price actually paid.
Basically, share valuation methods that exist can be classified into the following categories:
- Methods based on book value: Are those that determine the value of the company based on its balance sheet. Therefore, it is a static valuation, which only takes into account the situation of the company at a specific and certain time.
- Methods based on discounted cash flows: The valuation of the company is calculated as the net present value of its future cash flows. The flow of money or cash flow measures the cash generated by the company; it is calculated from the net profit of the company, adding the amortizations, depreciations and provisions, and subtracting the investment in working capital and in fixed assets. Thus, this method affects the company potential to generate resources.
- Methods based on stock market ratios: This method is based in valuing a company looking for similar ones (sector, size, etc.) that are listed on the stock exchanges to apply the same ratios and compare them.
Example: A company has a share capital of 100,000 c.u., divided into 1,000 shares.
Therefore, the nominal value, that is, the value of the shares at issuance, is the result of dividing the company share capital by the number of shares, which in this case is equal to 100 c.u.
This nominal value does not have to coincide either with the book value, which is derived from the balance sheet and is equal to the quotient between the sum of capital and reserves and the number of shares, in this case, 140 c.u., nor with the market value, which may be greater than, equal to or less than the book value of the company shares, which are subject to many variables that, to a greater or lesser extent, affect their price. These are the main variables that influence the share price: The general economic situation, the evolution of the company, the earnings forecast, regulatory changes…
On the other hand, assuming this company holds an indebtedness of 50,000 c.u., that its dividend per share is 10 c.u.,that its equity amounts to 140,000 c.u., that its EBITDA is 70,000 c.u., that the annual result for the year is 30,000 c.u. and that the share price or market value is 80 c.u., and therefore, the company valuation on the stock market or market capitalization, which is calculated multiplying the number of shares by the share price, amounts to 80,000 c.u., the main indicators can be calculated:
The prime ratio is the P/E (Price to Earnings Ratio), which is defined as the quotient between price per share (80 c.u.) and earnings per share (30 c.u.), being in this case equal to 2.67.
The PER provides different information:
- It reflects the multiple of the earnings per share paid by the Stock Exchange, that is, the number of times that investors pay the annual profit of a company (2.67 times).
- It can also be interpreted as the number of years that it will take an investor to recover their investment (assuming that the profits are maintained and that they are distributed in full). In the example given above, the P/E would indicate that it would take 2.67 years to recover the investment.
- The reciprocal of the P/E (1 / P/E), called the earnings yield, measures the return that the investor expects to receive with the purchase of the share, if it is assumed that the company profits will not change in the coming years and that the entire profit is distributed as a dividend. In the example given, it is 37.45%.
Other commonly used ratios are the following:
- Dividend yield: Dividend per share (10 c.u.) / Price per share (80 c.u.) = 0.125.
- Price / Book Value: Which compares the market value of the share (80 c.u.) with its book value (140 c.u.), that is, it indicates in what proportion, 0.57, the market is valuing the book value of the company.
- ROE (Return on Equity or financial profitability): Measured through the ratio “Profits / Equity”, 30,000 c.u. / 140,000 c.u., the company’s ability to generate profits with the shareholders’ own resources (share capital + reserves), standing, in this case, at 21.43%.
- Debt / EBITDA: This ratio includes an indication of the company’s ability to undertake additional debt and to refinance the one that is due. It is, therefore, a ratio that measures the relative level of leverage (debt undertaken).
EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) represents the gross operating profit or margin, that is, the profit before interest, taxes and depreciation/amortization. The debt / EBITDA ratio indicates how many years will be necessary to pay off the entire debt using the operating result, in the example shown it would be 0.71.
On the other hand, in the case of this financial instrument, it is crucial to know and assess its essential characteristics, so that the investor can match the potential levels of risk and return inherent in this type of assets with their ability to bear losses and with the return objectives and the time horizon of your investment.
In the same way, it is very important to know the variables that influence the valuation of shares: Corporate profits, interest rates, macroeconomic data, etc. Their knowledge and follow-up will allow the investor a more prudent and efficient management, by generating investment ideas with greater criteria and based on their own expectations.
An adequate valuation of the investment in shares must take into account a medium- and long-term horizon, given the potential to add value to the shareholder, through the distribution of dividends, the allocation of reserves of the companies and the attainment of profits on their sale.
