Valuation plays a very important role in knowing whether the company is worth investing at certain levels or not.
Stock market tells you the price of everything but not the value of anything. What is the value of any company in market can be known by its market capital which is
MCap = Current Share price x No. of shares issued by the company
This market capital roughly tells you how much you have to spend if you want to buy the whole company now itself. If you wish to buy the whole company, you have to buy all its shares at the price offered in the market or at the current market price.
Is market capital enough?
The price of shares fluctuates a lot in the market and many times market capital doesn’t actually tell about the right worth of the company. If it is a bull market the stock prices will be very high and this will increase the market capital also. In the bear market stock prices can be very low and market capital can be well below the actual worth of the company.
There is a better way to the known value of the company , it is called enterprise value. Which reduces the debt company has, and adds the cash it has. When you buy the whole company, you will get control of the cash and the investments it has, therefore you can reduce that amount from the market price.
Enterprise Value(EV) = Market Capital – Cash and Cash equivalents.
When you buy the whole company, its debt burden also gets transferred to you, and you are only going to repay that debt. It makes sense therefore to add the debt the company has when calculating the enterprise value.
EV = Mcacp – Cash + debt
This is the actual debt and cash adjusted amount one has to spend, if he wants to buy the whole company.
Need any example?
Sure, Let’s say a company X has a market capitalization of 30,655 crores, the total debt on its balance sheet is 2144 cr and the balance sheet shows that the company has cash and liquid investments of 2870 cr. Then it’s EV will be
EV = 30655+2144-2870 = 29929 crore
How EV can be used in valuation
EV tells you the worth of the company. By knowing how much the company with this worth is earning you can make the decision whether it’s worth investing or not. You can compare EV with the operating income, the net income or the income before tax of the company, to estimate how much return it can give you. I prefer Operating Income, also known as earning before interest and tax(EBIT). EBIT/EV is also known as Earning Yield.
Let’s say the EBIT of the company X is 1600 crore. Assuming if these earnings are going to remain constant, what I can get by investing in this company is
= (EBIT/EV )x 100
= (1600/29929)x100 = 5.3 %
So, I should avoid investing as returns possible are 5% only?
The answer to this question can be yes and no also. Most commonly, it should be avoided as the returns are 5% only and you can make more from fixed deposits and bonds. But I have assumed here that earnings to remain constant and it’s not necessary that earnings will remain constant. They can increase also. If the operating income doubles to 3200 from 1600 in the next two years. My estimated profit can double
= (3200/29929)x100 = 10.6 %
Earning can go down also! That also possible. If the EBIT becomes half in the next two years the estimated profit goes down to
= (800/29929)x100 = 2.6 %
Earnings of the company are same, but the share price has fallen 50% and the new market capital 15200 crores rest everything like debt and cash are same. The new enterprise value in this situation will be.
EV = 15200+2144-2870 = 14474 crore
The earning yield now will be
Earning Yield = EBIT/EV x 100
= (1600/14474)x100 = 11%
You can see here operating income, debt and cash all same here but earning yield has doubled, just because there is a crash in the stock market. Therefore I love crashes in the market. When you buy anything at low prices your downside gets minimized and upside gets maximized. The lower you buy the safer your investment will be.
The moral of the story
You can invest at low EBIT/EV also if you are confident that earnings of the company are going to improve. You can suffer loss even at very good EBIT/EV if the company’s earnings fall. It all depends on the company’s future earnings.
To have a better margin of safety, it’s always good to invest at high EBIT/EV and you expect that company’s earnings won’t fall and they will grow.