Price Earnings Ratios and Valuations
Price Earnings Ratios and Valuations
By Charles Hattingh CA (SA) Chartered Financial Analyst
“What is wrong with the price earnings ratio as a method for valuing shares? I have always used this approach and it has worked for me in the past.” “When I value a private company I merely multiply the adjusted earnings of the company by a factor of three.” These two comments crop up occasionally during my valuation workshops. The purpose of this article is to try to persuade you to abandon the price earnings ratio method (PERM) of valuing an entity or share therein and to adopt a more conceptually pure methodology.
By definition a price earnings ratio is the price or value of the share or entity divided by the earnings or earnings per share. This equation contains three unknowns:
1. The value of the company or share.
2. The earnings or earnings per share.
3. The price earnings ratio.
Those using the PERM analyse and adjust the past earnings and make adjustments to arrive at maintainable and sustainable earnings. They are left with one equation and two unknowns. Without the price earnings ratio one cannot arrive at the value and without the value one cannot arrive at the price earnings ratio. So the trick is to find one or more “similar” listed shares and make adjustments to their price earnings ratios to arrive at a price earnings ratio that is applicable to the entity or share being valued. This eliminates another unknown so that the equation: Value = PE ratio x maintainable and sustainable earnings can be solved.
The two major problems with this methodology are:
1. It is subjective in that there is no proven method for converting the PE ratio of a listed company to one applicable to the entity being valued. Johannesburg participants of the workshops tell me that “three is a good number” whereas in Cape Town I am told that “six is a good number”. There could be an arbitrage possibility here if anyone cares to investigate!
2. The method focuses only on one aspect of the company and that is earnings. It ignores the asset values and ability of the company to generate cash flows, among other things.
Most merchant banks use the free cash flow method to value shares. They analyse the past financial statements of the company and do a thorough due diligence of the company’s affairs. They then construct a financial model to project the free cash flows of the company making certain assumptions about key determinants such as growth in revenue, margins, working capital levels, plant replacements, etc. They then discount these cash flows at an appropriate discount rate. This gives them the value of the operating assets of the company. To this they add the value of the non-core assets and deduct the value of the non-operating liabilities. After making some adjustments for items such as secondary tax on companies, they arrive at the value of the entity. This methodology is a conceptually sound approach to valuing an entity or share.
Accountants do not feel comfortable with the free cash flow method as it is easily attacked, i.e. one can see the future cash flows on which the valuation is based. So they hide behind the crude PERM. However, there is a middle path available between the price earnings ratio method and the conceptually sound free cash flow method. I have called it the sustainable cash flow model (SCFM). This model is conceptually sound and arrives at a price earnings ratio that takes all the determinants of value into account. After performing a thorough due diligence examination of the entity, the following determinants are established (the amounts in brackets are for illustrative purposes):
1. The equity of the entity fairly valued (500).
2. The share capital, share premium and capital reserves (100).
3. The maintainable sustainable earnings before secondary tax on companies (STC) (150).
4. The dividend paid in the previous year (50).
5. The pre-tax return required on gilt investments (12,0%).
6. The investor’s tax rate (40%)
7. The systematic risk premium required on the JSE (6,0%).
8. A beta to modify the systematic risk so that it is applicable to the entity (0,8).
9. The unsystematic risk premium required for this investment (5,0%).
10. The return expected to be earned on earnings ploughed back by the entity (20%).
11. The discretionary cash flow expected to be declared by way of dividends (40%)
12. The year in which dividends to members is expected to commence (year 1).
13. The rate of secondary tax on companies (12,5%).
14. The expected life of the entity as a going concern (20 years).
15. The proportion of net assets expected to be distributed at the termination of the entity (80%).
Based on the figures in brackets, the price earnings ratio for the entity using the SCFM is 6,2.
The table below illustrates how the price earnings ratio is affected by changes to some of the figures in brackets above. Hopefully, these effects will be self explanatory to anyone with some knowledge of the dynamics of valuations.
|Determinant |Above |PER |New |PER |
|Equity |500 |6,2 |-500 |6,0 |
|Earnings |100 |6,2 |50 |5,6 |
|Gilt rate |12,0% |6,2 |10,0% |7,0 |
|Systematic risk |6,0% |6.2 |5,0% |6.7 |
|Beta |0,8 |6,2 |1,3 |4,7 |
|Unsystematic risk |5,0% |6,2 |10,0% |4,0 |
|Return on PLB |20% |6,2 |15% |4,9 |
|Discretionary CF |40% |6,2 |10% |6,5 |
|First dividend |Year 1 |6,2 |Year 5 |6,6 |
|STC |12,5% |6,2 |10,0% |6,4 |
|Life |20 |6,2 |40 |7,1 |
I am encouraging those who do fiscal valuations to collect evidence to support each determinant arrived at, to document and store the evidence for retrieval in the event of any challenge to the valuation and to formulate an opinion on the determinant from the evidence collected. If the job is done in a professional manner and the valuer is independent and seen to be independent, the probability that the value will be challenged will be reduced.
Once the PE ratio has been derived from the conceptually pure SCFM, it can be tested to see if it is reasonable by comparing it with PE ratios of similar listed companies and giving explanations for any difference between the two ratios.
Is this not a far better way to arrive at a price earnings ratio? Here is a challenge for the more enthusiastic readers: have a go at constructing the model used to arrive at the PE ratios above.
Note that non-core assets and non-core liabilities in the entity being valued are dealt with separately. The value using the SCFM is adjusted by these items after applying a suitable discount depending on the circumstances.
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