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Valuation Metrics
By Financially Fit Staff
Market capitalization, or "market cap" for short, is the number of shares outstanding multiplied by the per-share price. As an example, a company with a share price of $10 with 100 million shares outstanding would have a market cap of $1.0 billion. If this same company had 200 million shares outstanding and the price per share were $5, the market cap would remain $1.0 billion.
As an extension of this, valuations are really assessments of market capitalization as compared to the company's intrinsic value - with a company's intrinsic value defined as the sum of all future cash flows discounted back to the present. If discounted cash flow valuation reveals the intrinsic value or theoretical value of the company to be below its current market cap, then the company's shares are undervalued.
Although this concept seems fairly straightforward, today's investing climate is anything but that. Few companies trade at a price 1X the sum of all future cash flows discounted back to the present, but rather trade at multiples several times that of the sum of all future cash flows discounted back to the present. Peer and industry comparison is used to reveal what is a fair multiple of discounted cash flows - in a nutshell, this reveals the all-important figure of how much other investors are willing to pay for cash flows within a given industry.
But discounted cash flow analysis is complicated and requires several inputs and assumptions - miniscule changes to these inputs can lead to large swings in valuation. In a way, the Price to Earnings (P/E) multiple is a simplified version of this concept, with the difference being that the price is based on the future stream of expected earnings rather than cash flows.
But how do you value a firm when the company is operating at a loss and analysts aren't calling for earnings either this year or next?
The Price to Sales (P/S) ratio is one tool that can help in making an informed investment decision. Price to Sales is easily calculated - divide the market capitalization of the company by its revenues for the trailing twelve months. Generally speaking, the lower the number is, the better it is. However, it's important to understand that a price to sales ratio is meaningless as a stand alone metric.
Much like with any pricing metric, the Price to Sales ratio must be evaluated in the context of the industry or peers. It is imperative that you use the Price to Sales ratio to compare only companies in the same industry because, much like P/E ratios, there will be differences among industry groups.
We find the Price to Sales ratio to be particularly useful in valuing firms that are not yet profitable. Further, we often use it in conjunction with the P/E multiple to screen for unusual events. If the two ratios provide contradictory views, this could be an indicator of a one-time event that may have distorted the financials on a temporary basis. An example of such an event could be something as simple as a one-time tax benefit that applies only to the current year or a one-time payment stemming from litigation. Were this to occur, it becomes crucial to "normalize" earnings, weeding out unusual events that could lead to inflated EPS figures. Since the P/E multiple is based on the future stream of expected earnings, deriving a price by multiplying earnings that include "unusual" events that add to earnings could lead to an inflated valuation.
This concludes this week's issue of Financially Fit. We encourage you to visit our website to review past issues of Financially Fit:
http://www.brokeradviser.com/newsletter.cfm
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