In search of the Magic Wand to Value Equities

Before we embark on the journey of finding out the magic wand to value equities, let us understand the determinants of equity values

Determinants of Equity Value

When you own and operate a business like say retail garments shop or a bread factory, you are in effect earning from selling the garments or baking the breads. Your profits are wholly and solely derived from your business activity. However, when you invest in stocks your income comes from the following three sources:

1.       Initial Dividend Yield

2.       Growth in Earnings

3.       Change in valuation (Price / Earnings Ratio).

I explain these three return sources from stocks very briefly for those of you who are not familiar with it. Dividend is nothing but the distributed earnings (profits) of the company and when it is expressed as a ratio of the stock price it is termed as Dividend Yield. Growth in earnings is the profits made by the company over your holding period of the stock. In the example of garments retailer or manufacturer of breads it would mean the profits derived from the sale of garments or breads, respectively. The third concept is the change in the Price / Earnings (P/E) multiple. P/E is nothing but the market price of the stock divided by the earnings (profits) of the stock. It means how many times earnings is the market ready to pay for a company. Suppose, the P/E multiple of a stock is 10 it simply means the market is ready to pay 10 times today’s earnings for buying the entire company. Today, the market might be ready to pay 10 times earnings –it all depends on the expectations of future earnings and profitability of the company – if the expectations increase, the market would be ready to pay a higher multiple of say 12 times while if the expectation of future earnings decreases than the market would like to pay a lower multiple of say 8 times. This brings me to the third source of return from stocks which is change in the P/E multiple, an increase in the P/E multiple would result in a positive change in the stock price while a decrease in the P/E multiple would result in a negative change in the stock price. Kindly note, that the first factor of dividend can be positive or in worst case zero while the second and third factors can be positive, zero or even negative because the company can make losses also and the P/E multiple may contract also.

The best valuation Tool for Equities

Equity prices are valued in comparison to what they give the investor in return for the money paid for them. Generally, equities give us the following in return for the price paid for it:

Ø       Earnings

Ø       Sales

Ø       Book Value

Ø       Replacement value

Ø       Dividends

 

When you divide the current market price by any of the above mentioned items, it denotes how many time the current “value determinant” is the market ready to pay in terms of price. For example, when we compute equity values based on earnings, we divide the current market price share by the earnings per share (EPS) which in ratio form would be denoted by the P/E ratio.

Now, let us examine each one of the above tools so as to search for the magic tool to value equities.

Ø       Earnings

Valuing the price of the stock against its earnings or the P/ E ratio is the most common valuation tool used by market participants. I don’t know the reason for it but its simplicity, intuitiveness and fundamental inclination calls for its wider use. As mentioned earlier, it simply depicts the number of times the stock price is quoted in terms of the company’s current earnings. All other things being equal, a stock with a low P/E multiple is more attractive than a stock with a high P/E multiple. However, rarely are all the other things equal. For example, in a commodity company a high P/E might infact signify a good buying opportunity provided the high P/E is not because of high P but because of the E being at a cyclical low and expected to rebound from thereon. However, earnings can be very volatile and difficult to predict. Further, earnings can sometimes be slaves to accounting policies and gimmicks.

Ø    Sales

The other common valuation tool is used to compare price with the Sales of the company via the Price / Sales (P/S) ratio. The major flaw with this valuation tool is that it gives importance only to the topline (sales) and not the bottomline (profits). Thus a loss making company with high growth rate in revenues might command a high P/S ratio. Also, its easy for a company to increase sales by selling additional goods on credit to sub-standard customers which will result in higher sales and correspondingly increase in debtors.

Ø    Book Value

This is another exciting valuation tool – the relationship between the price and the book value of the company. The book value is nothing but the net wroth of the shareholders – it is derived by adding up the company’s assets (owned) and from it subtracting the company’s liabilities (owed) and then dividing it by the number of shares so as to get the book value per share. However, book value is more of a theoretical value of the company’s assets. It might not reflect the current value of its assets because accounting is on historical cost basis. Further, the net worth might not be the actual worth of the company because assets are only worth what the buyer is ready to pay for it. Importantly, the assets should be able to generate sales and income otherwise it is useless.  

Ø    Replacement Value

In an inflationary environment, book values of assets tend to be under stated and hence we have to look at the “current value” or in other words the “replacement value” of the assets. Stock price divided by the replacement value yields the Q-ratio. While superior to indicators that merely use book value, it is almost impossible to calculate, and is of greater interest to theoreticians than to practicing investors.

Ø       Dividends

Although every equity investor is familiar with dividends but very few appreciate the worth of it and actually invest for it. When you invest in a bond or take a bank fixed deposit, what essentially are you investing for – interest. But, when you invest for in equities what primarily is your primary motive behind investing in it – for a majority - it is capital gains. And when you invest for capital gains, there are good chances that you might actually loose rather than gain. Dividend is nothing but the distributed profits of the company in cash to the shareholders. Therefore, to pay dividend the following is required:

a)       Profits

b)       Actual Hard Cash

c)       Intention of the management to distribute the cash from the profits by way of dividends

Dividends by far are the most simple, real and superior valuation tool than the others. Let us see how it fares when compared to the others:

Dividends vis-à-vis Earnings

Ø       Earnings are accounting profits while dividends are real hard cash. A company with forged accounts can show higher income but may not be able to pay bigger dividends because of lack of actual hard cash for paying dividend.

Ø       Dividends are more stable as compared to earnings which can be volatile and erratic.

Ø       Earnings can become distorted during severe economic crisis. For example, during the market bottom in the US after the great depression of the 1929 to 1933, the P/E ratio of the Dow Jones industrial Average (DJIA) was 30 times. A high P/E ratio of that magnitude would reflect extensive overvaluation and considered bearish. However, the high P/E ratio in the US in the year 1933 simply reflected the abysmally low earnings and not high prices. In contrast, the Dividend Yield of the DJIA reflected the correct picture of the market’s undervaluation by surging past the 10% mark.

Dividends vis-à-vis Sales

Ø       Sales only concentrates on topline growth and not on bottomline i.e. profit growth while dividend is nothing but distributed profit to the shareholders.

Ø       Its easy for a company to manipulate its sales by selling additional goods on credit to sub-standard customers which will result in higher sales and corresponding increase in debtors but very difficult to manage dividends because it is nothing but hard cash.

Dividends vis-à-vis Book Value

Ø       Book value is a theoretical measure based on historical prices while dividends are actual hard cash paid out of current profits.

Ø       A company can have a very high Book Value but low earnings and dividends if the funds are blocked in unproductive assets while since dividends are paid out of profits, the assets of the company have to earn those profits so as to enable the management to pay dividend to the shareholders.

Dividends vis-à-vis Replacement Value

Ø       It is very difficult to accurately compute the replacement value while dividend numbers are easily available.

Ø       Replacement value can be manipulated to account for higher inflation but dividends, being hard cash, cannot be.

Conclusion

To conclude, of all the major yardsticks used to value equities, dividends by far is the most superior of all. Hence, don’t ignore dividends in the name of growth or capital gains. Whether it is life or investments, get the ground level basic right with realistic expectations, and there is nothing as real as hard cash in the form of dividends. So, the next time you ignore dividends then do it at your own peril. Therefore, the next time when you invest, do give prime importance to dividends as it is the magic wand to value equities.