In any business we have two things to study. The Asset ( Money invested in business i.e. Equity and Debt) and earnings in the business from that Asset.
For example, you have opened up a shop with an Initial Investment of 100k from loan and 100k from Equity (FV=10). Then after one year say you have earned a profit of 50k from the business.
Asset invested= 200k
Earnings on the Asset = 50k
Book Value= 10
Now to value and select this business there are certain defined ratios and parameter available in the financial world. Let us discuss and try to relate them with Asset and Earnings.
A> Asset Based Parameters:
P/B– The Book Value is nothing but (Asset-liability/No. of Shares). The value less than 5 is generally considered a reasonable valuation. However, the companies are always valued as compared to their peers.
ROE– The Return on Equity is a parameter which indicates how much money the company is earnings on the Equity invested. In the above example the ROE is 50%.
In general, ROE above 25% is considered excellent.
ROCE – The ROCE indicates Return on Capital Employed . The Capital Employed means the total Debt and Equity that goes in the business to start it. In our example Capital Employed is (100k Equity and 100K Debt). The formula for calculating ROCE is (EBIT/Capital Employed).
The ROCE would be 60k/200k=30%.
In general , ROCE above 25% is excellent.
B>Valuation based Parameters
P/E– The Price to earnings indicates at which price share is available to its earnings. The value less than 15 is generally considered good. However, the P/E multiple always be compare with peers to judge its valuation whether it is overvalued or undervalued.
M.cap/Sales– Sometimes many companies fudge their Profit n Loss Account and shows higher profit because of which P/E looks cheap. However, the Mcap/Sales is good testing parameter in those circumstances as it values company based on Sales which is hard to manipulate. Mcap means (number of Shares*price of share). The value less than 2 considered good. However, the P/E multiple always be compare with peers to judge its valuation whether it is overvalued or undervalued.
EV/EBITDA- Till now in P/E and Mcap/Sales parameters the debt is nowhere considered. If suppose company has financed business more on debt and less on equity than naturally the EPS would be high making P/E looks cheap. To overcome this problem, another parameter was defined.
EV= Mcap+ Debt – Cash
EBITDA= Earnings before Interest, Taxes, Depreciation and Amortization.
The Value less than 10 is generally considered good.
If investor learns these methods, then I can say with the claim that you can value any company in the world. Hope you liked the above article. If any query is there, simply drop a message in the comments section.