Interest rate differentials between the US and Australia are set to narrow further, creating Foreign Exchange opportunities for investors
Nick Ryder, NAB Private Wealth Investment Strategist, explains the different ways analysts and fund managers value listed company shares.
Share valuations are widely used in the financial services industry by fund managers, research analysts, investors and companies to make investment decisions, but often the share prices of listed companies may not reflect “fair” value. However, calculating the fair value of a share is not an exact science and depends on the type of company, the sort of valuation being undertaken, the industry and other factors which require some judgement on by the analyst or valuer.
The most common way analysts value listed shares is on the basis of comparable multiples, for example, price-to-earnings or cashflow multiples. For example, if the company is expected to earn a net profit after tax of 30 cents per share this financial year and companies in the same industry are currently trading on an average price to earnings multiple of 13 – 16 times then the shares should be worth about $3.90 – $4.80 each. Analysts may also make adjustments to the multiple if the company being valued has better growth prospects or a stronger market position than its peers.
Another methodology used to value shares in a company is to value the entire business and then subtract any net debt to calculate the value of the equity and then divide this by the number of shares on issue.
The most common valuation methodology is to multiply gross earnings before interest, tax, depreciation and amortisation (EBITDA) by EBITDA multiples applying to either listed peers (trading multiples) or multiples applying to recent transactions where a comparable business may have been sold (transaction multiples). Transaction multiples are typically higher than trading multiples given the premium for control that a corporate acquirer is prepared to pay to buy the entire business as opposed to the lower trading multiples portfolio investors are prepared to pay for small share parcels on the stock exchange.
For companies that are unprofitable because they are start-ups or in a bankruptcy situation, it is not always appropriate to multiply negative earnings by a multiple. In such situations, the valuer or analyst may use revenue multiple or other benchmark ratio to value the company and its shares.
Asset rich companies such as property and investment companies may also be valued on the basis of the company’s assets, that is, its net tangible assets per share. Alternatively loss makers and mining businesses with limited life projects may be valued using the net present value of discounted cashflows (DCF) methodology which converts forecast future net cash flows (which may be negative to begin with and then become positive) into a present value using a discount rate applicable to comparable businesses.
For some diverse or conglomerate companies which have diverse businesses, analysts often use a “sum of the parts” valuation which may use different earnings multiples and different valuation techniques (for example, DCF, multiple based or net asset value) for different parts of the company and then aggregate these and subtract an debt and head office costs to arrive at a value for the equity and shares. This is likely to give a more accurate valuation than attempting to use a single earnings multiple to apply to the aggregate earnings, particularly if one part of the business is loss making and therefore depressing the aggregate earnings.
© National Australia Bank Limited. ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.