Sunday, March 7, 2010

A common form of corporate ownership – Valuing Shares

Both companies and real estate are assets; they are financed through debt and equity. The mortgage/down payment ratio or Loan to Value ratio (LTV) is a common parameter used in real estate, while corporations use a debt/equity ratio. Upon closer examination you may realize that real estate and corporate financing have a lot in common.

A company’s total asset value is the sum of its equity and debt; just like that of a real estate property. The capitalization ratio or cap rate used in real estate is the fraction of net operating income over property value. You could do the same for corporations – here net operating income is referred to as EBITDA, i.e. earnings before interest, taxes, depreciation and amortization. Sometimes EBITDA is compared with funds from operations.

You may consider determining the ratio of EBITDA over Total Assets Value which would be equivalent to a cap rate. If the ratio is greater than the weight averaged interest rate paid on its corporate debt, there is a positive effect of leverage on corporate earnings just as in case of the cap rate being greater than the combined mortgage interest rate in real estate. When the interest rate is higher than these ratios, we have negative leverage and the shareholders/real estate owners are actually subsidizing the operations in the speculative hope that corporate assets or real estate value will somehow appreciate. This is an unhealthy situation.

Many a corporation uses the interest coverage ratio
to determine how easy it can handle its current debt. The interest coverage ratio is EBIT (earnings before interest and taxes) over interest expense. A ratio of less than 1.5 is often considered worrisome.

Debt ratios are very crucial in determine the ‘quality’ of a corporate earnings because the debt enhances the ROI or return on investment significantly. ROI is earnings divided by equity. If the shareholder equity is too low compared to debt, the ROI is very high. For example $10 earning on $20 equity and $200 debt results in a ROI of 50%. However, the ROI on those same earnings is only 9% if the equity was $110 and debt was $110 (same total asset value). However, what would happen if earnings decreased by 20% to 8 dollars? ROI would drop from 50% to 40%, a 10% decrease, while in the low leverage case it would fall from 9% to 7.2%, a 1.8% decrease. So the higher the leverage the more sensitive your ROI is to a change in earnings.

Net Income is earnings after deducting interest, corporate taxes, depreciation and amortization. Net cash flow in real estate is the same except that it excludes principal repayment on mortgages. In corporate earnings cash flow includes funds raised from the sale of shares, issuance and repayment of debt, repurchase of shares and dividend payments to share holders. Hence Net Cash flow from real estate and cash flow statements from corporations should not be compared.

The equity owned by the company’s shareholders is sometimes called the company’s book value. When divided by the number of outstanding shares it is called book value per share. Conversely, when multiplying a company’s share price with the number of outstanding shares, this is usually referred to as its market capitalization.

When a share is traded or priced on the stock market, it is often priced higher than the book value; this is expressed as the share value over book value ratio or share/book ratio. In bear markets, companies may be valued less than their book value and the ratio is then below 1. Typically the ratio is around 1.2 but in ‘momentum plays’ or for ‘high growth’ companies such as Google, the ratio maybe as high as 10 – in Dec 2009 Google’s book to share was close to 5.

Investors in that case speculate that a company is to expand dramatically and that net earnings will increase manifold or that a company will turn from loss to high profits in a relatively short time span. Whether this is true remains to be seen, and when the performance of such companies disappoints the investor community, their share prices may fall dramatically.

Instead of the price to book value, investors may look at the price/earnings ratio of a company. This is the ratio of (net) earnings over the share price. This is akin to interest rates on a loan and often the P/E (or better earnings yield - E/Px100%) is compared with interest rates on government bonds or other debt. This is one of the favourite numbers of Warren Buffett. How much earnings yield do I get from investing in company ABC compared to interest paid on a 5 year government bond. If the investor makes 10% on earnings yield and 2% on the interest rate, the investor is likely to decide that it is much more attractive to invest in shares of ABC. When enough investors feel that way, the share price is traded up in response to the increased investor demand until the earnings yield for ABC is considered comparable to that of the government bond taking into account the risks level of investing in ABC rather than the government.

For utility and communication companies with moderate growth, share prices used to trade at a P/E of 10 or an earnings yield of 10%. Canadian Banks also traded a number of years ago at a P/E around 10, but over the last decades, banks became much more aggressive and increased their leverage to much higher levels to meet investor expectations of ever higher profits. Currently banks trade at P/Es of 15 and higher or an earnings yield of 1/15x 100= 6.66% which still compares well with today’s artificially low interest rates close to 0%. In December 2009, Google's P/E was around: 30 and in Dec 2007 it was as high as 50.

These ratios also help us understand the effect that an interest rate increase may have on the stock market. What if the Bank of Canada decides to increases its interest rate on short term loans by 1 or 2% as may happen when inflation rears its ugly head or when economic growth becomes too fast?

Now the picture of valuing a share price becomes murky. Not only does the spread between earnings yield and interest rates narrow, companies are likely to pay more interest on their loans, reducing earnings. Also consumers may take out less debt reducing their purchase of consumer goods from the companies and thus reducing corporate earnings even further. The result is that investors no longer can accurately forecast how much companies may earn per share other than sensing that earnings are likely to decrease. The reduced earnings and increased uncertainty will result in lower share prices, possibly significantly lower prices.

Thus we enter the vagaries of the stock market. Something feared by many investors – but is this fear justified? Maybe not, we’ll discuss that in later posts.

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