Learning how to value company shares is not easy and my understanding of company shares is a work in-progress. A work in-progress like a new house being built that isn’t even watertight.
Shares are partial ownership of a company. Buying shares in a company like BP means that you are part owner of the business (a shareholder). You are therefore entitled to a share of the profits.
Profits are paid out in the form of dividends and this is normally annually. It is fair to say that many companies won’t be paying out dividends in 2020 for obvious reasons.
WARNING – if a company issues and sells new shares, it means the value of existing shares will be diluted.
A popular method of looking at the share price of a company is to look at the price/earnings (p/e ratio), and this is the most recent years earnings per share (EPS) divided into the share price.
Lets look at two companies for comparison (Company A and Company B). Company A has p/e ratio of 10. The share price is £10 and you get £1 of profit for every share (10/1 = 10).
Company B has a p/e ratio of 12. The share price is £6 and you get 50p of profit for every share (6/0.5 = 12). Although Company A is more expensive, it has a lower p/e ratio and therefore you get more for your money (if you invested £60 into A and B, A would give you £6 profit and B would give you £5 profit).
Dividend yield is the last full years payout divided by the share price, and is very easy to compare to something like redemption yield on a bond or the rental yield on a property.
For properties, rental yield is the annual income divided by the price. An annual rent of £5,000 divided by a purchase price of £100,000 would equal 0.05 or 5%.
ROI (RETURN ON INVESTMENT)
ROI is the annual profit (taking into account taxes and other costs) generated by an asset, divided by the total investment.
I have experience of dividend yield and ROI in terms of rentals and ROI is my preferred method when evaluating the profit of a potential property. This is because it lets me know what rate of return I will get on my investment.
Again lets look a property example. Annual profit is £3000 (RENT – (Mortgage, taxes and other costs)) / £25,000 (TOTAL INVESTMENT) = 13.3%. When compared to interest rates of savings accounts (<1%), I can see this is good investment.
Value investing has been popularized by Warren Buffet and is buying something for less than it is intrinsically worth. Estimating the likely returns from a company over its lifetime does this. Another easier method is to look at the value of assets on its balance sheet.
To see how much a company is “worth” look at the net asset value. Looking at Robert Kiyosaki’s Rich Dad concepts, this is calculated by adding up a company’s assets and subtracting the liabilities. If the proverbial shit hit the fan, this is what shareholders would own if the company wound up and repaid its creditors.
FREE CASH FLOW
This is operations money minus capital expenditure or money that can be invested into expanding the company. If a company has millions of pounds in reserve, it is a sign that its financial books are in good working order and that the company is performing well.
WHAT THE CEO IS LIKE
Is the CEO or senior management driven and dedicated to the cause. Make sure they are not trying to make the stock price rise so that they can cash out.
This information should be easy enough to find. There will be stories on-line relating to the CEO and you should get a feel for how the business is run at the senior levels.
Just look at Mike Ashley at Newcastle. Although he is a successful businessman and knows how to maximize profits and run successful businesses, he clearly doesn’t care about the long-term future of Newcastle football club. It seems from the outside looking in that him owning that club was all about personal gain from the very start.
HOW WILL VALUING SHARES HELP
The intention here is to improve my understanding of valuing shares so that I can go back and look at companies within my LS 80/20 fund (Vanguard). If I’m going to be investing for the next 20-30 years (current plan), I need to have 100% confidence in the fund I have chosen.
This will also benefit my kids, as it will help me to choose the right fund for their ISA’s.
DISCLAIMER – looking at the methods of valuing company shares, a brief description is provided. There are pros and cons of each method, but I have excluded any of the arguments for and against each method for simplicity.