Equity Valuations

Classification Earnings Valuation Revenues Valuation Cash Flow Valuation Economic Value Added Accounting Value Yield Valuations MembersValuation

Earnings Valuationprice-earnings P/E multiplierP/E Growth rate = P/E Multiplier / Growth RateP/E relative = (share P/E ) / (Index P/E)

Expected growth rate in Earnings Expected growth rate in Earnings = Reinvestment rate * ROI

Negative Earnings

Negative Earnings

Companies might belong to the cyclical industry. In such instances, in all economic situations, when there is a recession, the company will post negative earnings. However, once the economic variables change, the companies in these cyclical industries also recover and show a positive growth rate.

If the earnings of a cyclical firm are depressed due to a recession, the substitute earnings that have to be applied in the valuation process is the normalized earnings. Illustrations are the companies belonging to the automobile sector. Whenever there is recession, these companies operate at below the break-even capacity and post negative growth rates. Taking the average earnings over an entire business cycle can normalize earnings. Normalized earnings can be computed on the basis of net income or on the after-tax operating income. The formula for the computation of normalized earnings under these methods are:

Normalized Net Income = Average ROE * Current Book Value of Equity.

Normalized after-tax Operating Income = Average ROC * Current Book Value of Assets.

Once earnings are normalized, the growth rate used should be consistent with the normalized earnings, and should reflect the real growth potential of the firm rather than the cyclical effects.

The earnings of a firm may show a negative result due to a one-time unforeseeable charge. The extent of depression could depend on both external and internal factors relating to the company.

In such instances, the valuation can be done based on the estimates without considering the abnormality. Average earnings of the company can be used from the historical records to replace the present abnormal negative earnings. The time duration for considering the average earnings would depend on the nature of industry and that of the specific company.The earnings of a company could be negative due to poor management. The company might have a team at the top which made wrong business decisions or the company could have been affected by fraud or mismanagement issues. The negative performance could be in spite of positive earnings record in the industry / sector to which it belongs. However, if it is felt that the negative earnings due to this mismanagement has been deducted and corrective action by the company is on the agenda of the Board, valuation of such companies have to be done considering the industry earnings record.

The average return on equity or capital for the industry can be used to estimate normalized earnings for the firm. The implicit assumption is that the firm will recover back to industry averages, once management has taken the corrective measures. In this instance, the following formula can be used to compute the earnings of the company.

Normalized Net Income = Industry average ROE * Current Book Value of Equity

Normalized after-tax Operating Income = Industry average ROC * Current Book Value of Assets

The negative earnings recorded by the company had continued over several years and the management actions have not resulted in any improvement in the performance of the company. The result of this could be a significant reduction in the book value of the company over the time duration. The erosion of profits and assets of the company could be despite the good profits recorded by similar companies operating in the same industry / sector group.

To assess the value of these types of companies, the investor can use the average operating or profit margins for the industry in conjunction with revenues to arrive at normalized earnings. When the management has not taken any corrective action or the implications of the decisions are to be felt over a longer duration, the profit margin for the company could arise over a longer duration. The following formula can be used by the investors to arrive at the value of the firm using the earnings approach:

Normalized Net Income = Industry average net profit margin * Current Revenue.

Normalized after-tax Operating Income = Industry average operating profit margin * Current Revenue.

The earnings of a firm are depressed or negative because it operates in a sector that is in its early stages of its life cycle. This situation could also arise to a new establishment in an existing profit making industry. Mostly in these cases, the gestation period for posting a positive return from business operations could involve longer time duration.

The valuation of such companies will depend on what the perceived margins and return on equity will be when the industry matures or the average returns of companies in the existing sector.

The equity earnings are negative not due to operational mismanagement but due to high leverage or the interest burden of the company. The increased long-term obligations of the company coupled with increase in the interest rates may make the company to post negative earnings despite a positive result from the industry/sector.

The valuation of such companies must be from the viewpoint of the firm rather than that of equity valuation. Hence, valuation could depend on operational income / earnings rather than on the income to equity shareholders.

Earnings forecast

Earnings (value) = (1-t) * [ROA+(ROA-I)*(D/E)] * E

ROA = Return on assetsI = Interest rateD = Total long term debtE = Equity capitalt = tax rateForecasted sales = Industry sales target * company's share in industry sales

Forecasted earnings = Forecasted sales * profit margin

Forecast of annual versus quarterly results (Q2et - Q1et) = a + b (Q2e t-1 - Q1e t-1) + eQ2et = 2nd quarter earnings at year tQ1et = 1st quarter earnings at year tQ2e t-1 = 2nd quarter earnings at year (t-1)Q1e t-1 = 1st quarter earnings at year (t-1)

Revenues ValuationPrice to Sales Ratio = Market capitalization / One year total revenue.

Market capitalization = outstanding shares * current market pricePrice to Sales Ratio (PSR) = Market capitalization / Total revenue for a year.

Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt

Cash Flows Valuation

Economic Value Added (EVA) Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just use it. The most straightforward way for an individual investor to use cash flow is to understand the working of cash flow multiples.

Accounting ValuationBook value = Equity worth (capital including reserves belonging to shareholders) / number of outstanding shares

Book value = (Total assets - Long-term debt) / number of outstanding shares.

Price to book value ratio = Market price / Book value per share

Yield ValuationDividend Discount Models

The Zero-Growth Model

The Constant-Growth Model

The Multiple-Growth Model

Dividend Discount Models

V = D1 / kDividend yield = D1 / Po

Po is the current market price / traded price of the share.

The Zero-Growth Model

V = (D1 + P1 / (1+k)) P1 is the market price of the company in future.

V = (d1 / (1+k)) + (d2 / (1+k)^2) + (d3 / (1+k)^3) + (d4/(1+k)^4) + ((d5 + P5) / (1+k)^5)

The Constant-Growth Model

V = D1 / (k-g)

The Multiple-Growth Model

Members Valuation Subscription value multiplier

Other Valuation MeasuresInvestor Valuation of Shares

Valuation of Financial Service Companies

Valuation of Private Companies

Investor Valuation of SharesEquity multiples: P/E, PEG, P/S, and P/BV Whole firm multiples: EVA/EBIT, EVA/EBDIT, EVA/R&D, and EVA/SG&A Estimate growth rate in residual earnings

Methods to Calculate

Valuation of Private CompaniesAccounting ValueEconomic Value Added