Capítulo 2. Marco teórico
3. Capítulo 3: Metodología
3.12 Enfoque cuantitativo
Ratios in this group – sometimes called market ratios – measure the way the stock market rates a company by comparing the market price of its shares to information in its financial statements. Price alone does not tell analysts much about a company unless there is a common way to relate the price to dividends and earnings. Value ratios do this.
PERCENTAGE DIVIDEND PAYOUT RATIOS
Dividend payout ratios indicate the amount or percentage of the company’s net earnings that are paid out to shareholders in the form of dividends. There are two kinds of payout ratios:
• On combined preferred and common dividends
• On common dividends only Note the different divisor in each case.
Total dividends (preferred common) Net earnings (before ext
rraordinary items)
Item 47 Item 48 in Retained earnings q
100
statement Item 43 in Statement of earnings
or q 100 37 500 $ , $3350 000 1 086 000 100 387 000 1 086 000 100 35 68 , $ , , $ , $ , , . % q q Dividend on common
Net earnings (before extraordinary items)) preferred dividend
Item 48 Item 43 Item 47 or q q 100 100 350 $ , 0000 1 086 000 37 500 100 387 000 1 048 500 100 33 38 $ , , $ , $ , $ , , . % q q
Deducting the percentage of earnings being paid out as dividends from 100 gives the percentage of earnings remaining in the business to finance future operations. In our first example,
35.68% of available earnings were paid out as dividends in the year, therefore 64.32% was reinvested in the business.
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Dividend payout ratios are generally unstable since they are tied directly to the earnings of the company, which change from year to year. The directors of some companies try to maintain a steady dividend rate through good and poor times to preserve the credit rating and investment standing of the company’s securities. If dividends are greater than earnings for the year, the payout ratio will exceed 100%. Dividends will then be taken out of retained earnings, a situation that erodes the value of shareholders’ equity.
EARNINGS PER COMMON SHARE
The earnings per common share (EPS) ratio shows the earnings available to each common share and is an important element in judging an appropriate market price for buying or selling common stock. A rising trend in EPS has favourable implications for the price of a stock. In practice, a common stock’s market price reflects the anticipated trend in EPS for the next 12 to 24 months, rather than the current EPS. Thus, it is common practice to estimate EPS for the next year or two. Accurate estimates for longer periods are difficult because of the many variables involved.
Along with dividend per share, this is one of the most widely used and well understood of all ratios. It is easy to calculate and is commonly reported in the financial press.
Net earnings (before extraordinary items)preferred dividennds Number of common shares outstanding
Item 43 Item 47 Numb
e
er of outstanding common shares per Item 22
or $ ,1 086 000 3, $37 500 350 000 1 048 500 350 000 3 00 , , $ , , , $ . per share
Because of the importance of EPS, analysts pay close attention to possible dilution of the stock’s value caused by the conversion of outstanding convertible securities, the exercise of warrants, shares issued under employee stock options, and other changes.
Fully diluted earnings per share can be calculated on common stock outstanding plus common stock equivalents such as convertible preferred stock, convertible debentures, stock options (under employee stock-option plans), and warrants. This figure shows the dilution in earnings per share that would occur if all equivalent securities were converted into common shares. Since Trans- Canada Retail Stores Ltd. has no convertible securities, let us consider Company ABC, which had the following:
• 1,000,000 shares of $2.50 Cumulative Convertible Preferred Shares, $25 par, that are convertible into common on a 1-for-1 basis;
• 2,800,000 common shares, no par value; and
Earnings per common share using the formula above would be calculated thus: $ , , $ , , , , $ , , , , $ . 10 455 000 2 500 000 2 800 000 7 955 000 2 800 000 2 84 peer share
Fully diluted earnings per common share would require the following adjustments:
• Since the preferred dividends would not have to be paid if the preferred shares were converted into common shares, the earnings available for the common shares would increase by the amount of the preferred dividends deducted in formula; the total would be $10,455,000.
• The number of common shares would increase by one million, since a million preferred shares would be converted on a 1-for-1 basis.
The formula is then:
Adjusted net earnings (before extraordinary items) Adjusted common shares outstanding
$ , , , , , , 10 455 000 2 800 000 1 000 000 $ , , , , $ . 10 455 000
3 800 000 2 75 fully diluted earnings per sharre
Earnings from operations after all prior claims have been met belong to the common
shareholders. The shareholders therefore will want to know how much has been earned on their shares. If net earnings are high, directors may declare and pay out a good portion as dividends. Even in growth companies, directors may decide to make at least a token payment because they realize that most shareholders like to feel some of the profits are flowing into their pockets. On the other hand, if net earnings are low or the company has suffered a loss, they may not pay dividends on the common shares.
Describing net earnings in terms of common shares shows shareholders the profitability of their ownership interest in the company and whether dividends are likely to be paid. In the Trans- Canada Retail Stores example, net earnings are $3.00 for each common share. Since regular dividends of $1.00 per share per year are being paid on common shares, the calculation also indicates that the dividend is well protected by earnings. In other words, earnings per common share are $2.00 more than regular dividend payments.
Since common share dividends are declared and paid at the discretion of a company’s board of directors, no rules can be laid down to judge the amount likely to be paid out at a given level of earnings. Dividend policy varies from industry to industry and from company to company. Estimating the dividend possibilities of a stock may take into account:
• The amount of net earnings for the current fi scal year
• The stability of earnings over a period of years
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• The company’s working capital
• The policy of the board of directors
• Plans for expanding (or contracting) operations
• Government dividend restraints (if any)
Before a company can pay a dividend, it must have sufficient earnings and working capital. It is up to the directors to consider the other factors and reach a decision on whether to pay a dividend and how large the payment should be.
DIVIDEND YIELD
The yield on common and preferred stock is the annual dividend rate expressed as a percentage of the current market price of the stock. It represents the investor’s return on the investment.
Indicated annual dividend per shareq Current market price 1000
Assuming current market prices of $49 for the preferred and $26.25 for the common shares of Trans-Canada Retail Stores, the yields are:
Preffered: $49 Common: $26.25 $ . . % $ . . % 2 50 100 5 10 1 00 100 3 81 q q
Dividend yields allow analysts to make a quick comparison between the shares of different companies. However, to make a thorough comparison, the following factors must also be considered:
• The differences in the quality and record of each company’s management
• The proportion of earnings re-invested in each company
• The proportion of preferred and common shares in each company’s capitalization
• The equity behind each share
• In the case of preferred shares, the difference in preferred dividend coverage
All these factors should be taken into account in addition to yield – preferably over several years. Only then can an analyst make an informed evaluation.
PRICE-EARNINGS RATIO OR P/E MULTIPLE
The price-earnings ratio or P/E ratio is probably the most widely used of all financial ratios because it combines all the other ratios into one figure. It represents the ultimate evaluation of a company and its shares by the investing public.
Formula: Current market price of common Earnings per share (iin latest 12-month period)
Assuming that the current market price of Trans-Canada Retail Stores’ common stock is $26.25 and that its earnings per common share is $3.00, the P/E ratio is:
$26 25.
P/E ratios are calculated only for common stocks, not for preferreds. The only relevance of earnings to most preferred shareholders is how well (or by what margin of safety) they cover preferred dividends. The “preferred dividend coverage ratio” measures this best.
The main reason for calculating earnings per common share – apart from indicating dividend protection – is to make a comparison with the share’s market price. The P/E ratio expresses this comparison in one convenient figure, showing that a share is selling at so many times its actual or anticipated annual earnings. P/E ratios enable the shares of one company to be compared with those of another.
Example: Company A – Earnings per share: $2; price: $20 Company B – Earnings per share: $1; price: $10
P/E ratio for Company A: $2
P/E ratio for Company B: $ : 20 10 1 $ $ : 10 10 1 $1
Though earnings per share of Company A ($2) are twice those of Company B ($1), the shares of each company represent equivalent value because A’s shares, at $20 each, cost twice as much as B’s. In other words, both companies are selling at 10 times earnings.
The elements that determine the quality of an issue – and therefore are represented in the P/E ratio – include:
• Tangible factors contained in fi nancial data, which can be expressed in ratios relating to liquidity, earnings trends, profi tability, dividend payout, and fi nancial strength (balance sheet ratios)
• Intangible factors, such as quality of management, nature and prospects for the industry in which the issuing company operates, its competitive position, and its individual prospects. All these factors are taken into account when investors and speculators collectively decide what price a share is worth.
To compare the P/E ratio for one company’s common shares with that of other companies, the companies should usually be in the same industry.
In the Trans-Canada Retail Stores example, we calculated the price-earnings ratio on the earnings of the company’s latest fiscal year. In practice, however, most investment analysts and firms make their own projections of a company’s earnings for the next twelve-month period and calculate P/E ratios on these projected figures in relation to the stock’s current market price. Because of the many variables involved in forecasting earnings, the use of estimates in calculations should be approached with great caution.
The P/E ratio helps analysts determine a reasonable value for a common stock at any time in a market cycle. By calculating a company’s P/E ratio over a number of years, the analyst will find considerable fluctuation, with high and low points. If the highs and lows of a particular stock’s P/E ratio remain constant over several stock market cycles, they indicate selling and buying points for the stock. A study of the P/E ratios of competitor companies and that of the relevant market subgroup index also helps to provide a perspective.
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The P/E ratio comparison assists in the selection process. For example, if two companies of equal stature in the same industry both have similar prospects, but different P/E ratios, the company with the lower P/E ratio is usually the better buy.
As a rule, P/E ratios increase in a rising stock market or with rising earnings. The reverse is true in a declining market or when earnings decline.
Since the P/E ratio is an indicator of investor confidence, its highs and lows may vary from market cycle to market cycle. Much depends on changes in investor enthusiasm for a company or an industry over several years.
THE ENTERPRISE MULTIPLE (ENTERPRISE VALUE TO EBITDA)
The Enterprise Multiple (EM) is a commonly used measure of a company’s overall value, and is frequently used in capital-intensive industries such as the biotechnology, telecommunications, industrial and steel industries. It looks at a company’s enterprise value to its earnings before interest, taxes, depreciation and amortization, or EBITDA. Enterprise value (EV) is a measure of total company value at any given time and is calculated as the market value of the company’s common equity, preferred equity, and debt less the value of cash and cash equivalents recorded on its balance sheet. In this way, enterprise value reflects the actual cost to purchase the company as a whole.
Since the Enterprise Multiple takes into account the market value of company debt, it may be a more appropriate measure of value when comparing companies, particularly when analyzing companies with different debt levels. For example, because EBITDA uses pre-interest earnings whereas EPS uses post-interest earnings, the EM may provide a better measure of comparison compared to the P/E multiple.
Assume that the current market price of Trans-Canada Retail Stores’ common stock is $26.25, the market price of its preferred shares is $55.00, and that the value of the company’s debt is the value recorded on the balance sheet. For simplicity of this illustration, assume that the market value of the company’s debt is par. Enterprise value is calculated as:
Market value of common equity 350,000 × $26.25 $9,187,500
+ Market value of preferred shares 15,000 × $55 $825,000
+ Market value of debt Item 12 + Item 16 + Item 20 $3,100,000
– (Cash and cash equivalents) Item 1 + Item 2 ($2,169,000)
= Enterprise Value $10,943,500
EBITDA is calculated as:
Earnings before extraordinary items Item 43 $1,086,000
+ Income taxes Item 40 $880,000
+ Interest Item 37 + Item 38 $289,000
+ Amortization Item 32 $556,000
The Enterprise Multiple for Trans-Canada Retail is: Entreprise value EBITDA $ , , , , . 10 943 500 2 811 000 3 89
Enterprise multiples can vary depending on the industry and, similar to the P/E ratio, there is no standard. Trans-Canada Retail’s measure of 3.89 says nothing on its own. However, when compared with another company within its industry and with the industry standard itself, we can determine whether Trans-Canada is over- or undervalued relative to its peers. Higher enterprise multiples generally exist in high-growth industries, while lower multiples are found in slower- growth or mature industries.
EQUITY VALUE (OR BOOK VALUE) PER SHARE
Preferred shares rank before common shares in any liquidation, winding up, or distribution of assets. When their prior claims have been met, the holders of common shares are entitled to what is left.
The two equity value ratios measure the asset coverage for each preferred and each common share.
Preferred and common share capital contributed surplus re
ttained earnings foreign exchange adjustement Number of pre
fferred shares outstanding
Item 21 Item 22 Item 23 Item 25 N
u
umber of preferred shares as per Item 21
or $750 000, $ ,1 564,, $ , $ , , $ , , $ , , 000 150 000 10 835 000 60 000 15 000 13 359 00 shares 0 0
15 000, shares $890.60 per preferred share
As the foregoing example shows, each preferred share is backed by $890.60 of equity in the company. Since the par value of the preferred is $50 (as stated in the balance sheet), the equity backing is $890.60 ÷ $50, or 17.81 times. Analysts like to see that the minimum equity value per preferred share in each of the last five fiscal years is at least two times the dollar value of assets that each preferred share would be entitled to receive in the event of liquidation. Trans-Canada’s equity backing of 17.81 times far exceeds the minimum requirement.
If the preferred shares were redeemable at a premium on liquidation, the premium would be added to the par value in this calculation, slightly reducing the coverage. For example, a premium of $2.50 on liquidation would result in equity backing of $890.60 ÷ $52.50, or 16.96 times. As well as meeting the minimum standard for the industry, equity value per preferred share should also show a stable or, preferably, a rising trend over the same period.
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Common share capital contributed surplus retained earnings
foreign exchange adjustment (less preferred dividend arreears, if any) Number of common shares outstanding
Item 22 ttem 23 Item 24 Item 25I Number of common shares as per Item
22 or share $ , , $ , $ , , $ , , 1 564 000 150 000 10 835 000 60 000 350 000 ss
shares $36.03 per common share $ , ,
,
12 609 000 350 000
There is no simple answer as to what constitutes an adequate level of equity value per common share. Although a per-share equity (or book) value figure is sometimes used in appraising common shares, in actual practice the equity value per common share may be very different from the market value per common share. Equity per share is only one of many factors to be considered in appraising a given stock. Many shares sell for considerably less than their equity value, while others sell for far in excess of their equity value.
This disparity between equity and market values is usually accounted for by the actual or potential earning power of the company. The shares of a company with a high earning power will command a better price in the market than the shares of a company with little or no earning power, even though the shares of both companies may have the same equity value. Thus, we cannot quote a meaningful standard for an adequate book value per common share.