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The key to company value

In my last article I started to look at formulae and comparisons from

the share price pages which can be used to assess various aspects of

the financial situation of quoted stockmarket companies.

Before continuing with our look at these formulae it is worth

stressing the fact that none of them, in isolation, is particularly

helpful or instructive. Indeed, no combination of these formulae is

suggested as being a definitive guide to the current or likely future

value of the company&#39s shares.

This is not least because all these ratios can only absol-utely be

applied to the historical trading of the company and give little or

no indication of its future profitability (which includes its

profitability in its current accounting period, and even in its last

accounting per-iod where accounts have not been finalised or

released).

Thus, for example, a company&#39s earnings per share (eps) ratio and

dividend cover relate only to the last full accounting period, which

could have ended well over 12 months previously, since when the

company&#39s profits could have changed dramatically for better or worse.

Perhaps even more misleading, the price/earnings multiple compares

the company&#39s profitability for the last full accounting period (this

could be over one year old) with the company&#39s current share price.

The current share price should have factored into it any interim

trading statements or announcements made by the company, as well as

the market&#39s assessment of the trading environment in which the

company operates.

True, some investment commentators and publications attempt to

estimate these ratios for current and/or future accounting periods

and these can be useful pointers for investors. But these estimates

include a considerable degree of subjectivity and are frequently

revised, even mid-term, by their authors.

With these important caveats in mind I now pass on to a further

formula which is frequently used by investors and their advisers – a

comp-any&#39s net asset value (NAV).

This can be defined simply as the value of the company&#39s assets less

the value of its liabilities, with the resultant figure divided by

the number of shares in issue to give a figure for the NAV per share.

This can then be compared with the company&#39s prevailing share price

to, on the face of it (but this is far too simplistic to be taken at

face value, as I note below), identify shares priced lower than even

their net asset value and therefore represent good value for money.

Again, I feel that an example, continued from my last article, should

help illustrate some important points here.

Abacus plc made £5m pro-fit in the last full accounting period

and so, with 10 million shares in issue, its historic eps is 50p. Its

current share price of £7.50 shows a price/earnings multiple of

15 which, let us assume, is about average for its sector. This

indicates little overly positive or negative news about the company

known or anticipated by investment analysts following the company.

Now let us assume that the calculated net asset value of the company

is £100m. Dividing this by the 10 million shares in issue

results in a calculated NAV per share of £10.

This compares extremely favourably with the £7.50 prevailing

share price and appears to indicate that the company&#39s ability to

generate profit is being totally ignored from the share price – after

all, if the assets alone are worth more than the share price then

surely there should be some additional value placed on the future

flow of profits.

So what, in this assessment, might be particularly misleading and can

account for this apparent anomaly? Although, make no mistake about

it, anomalies such as this exist in real life but perhaps not to this

extent and not without some sort of explanation.

For example, the market might be expecting the company to be heading

for a period of severe losses which would result in a reduction in

assets or an increase in liabilities, or both – either way reducing

its NAV.

This is unlikely in our example as the company&#39s price/ earnings

(p/e) ratio would indicate this expectation (as we discussed in my

last article, the p/e would almost certainly be very low, and

certainly below its sector average).

Alternatively – and more likely in this example, I believe – is the

market&#39s assessment that the company&#39s assets could be overvalued or

its liabilities undervalued (especially, for example, where

liabilities are kept “off balance sheet”and do not enter into the NAV

calculation).

In the first category, many companies will include in their asset

base valuation an allowance for goodwill – for example, the value of

its branding, or an overvaluation of potentially obsolete, but

initially very expensive, machinery, or any number of potentially

misleading bases for valuing the company&#39s assets.

The opposite might be true, however, where a company adopts a much

more conservative approach to asset valuation and holds a significant

amount of property which, perhaps, has not been revalued for many

years or even decades.

In addition to all of these factors it is important to bear in mind

that the NAV calculation – as with the other ratios I have talked

about in my previous two articles – is almost always only shown on an

historical basis and therefore could be well out of date by the time

the information is collated within, or especially from, the published

accounts.

A notable exception to these warnings relating to the use of NAVs for

stockmarket companies in general are those in respect of investment

trust companies. Here, the NAV is calculated on a much more

consistent basis and therefore is much more reliable for use in

comparisons. The NAV within the vast majority of investment trusts

is, simply, the total value of the shares held within that trust.

Consistency comes within the method of assessing NAV, although

inconsistency still arises, of course, from the inconsistency of

valuation methodology within each of the company shareholdings.

Comparing an investment trust&#39s NAV with its share price indicates

either a discount, where the share price of the trust is lower than

the NAV, or a premium, where the share price exceeds the value of the

shares held within the trust.

On the one hand a discount indicates that a shareholder in the

investment trust could expect to benefit from increases in a greater

value of shares than his own investment indicates – a form of

“gearing” upwards of profitability – and might be sought after by

potential investors.

On the other hand such discounts – especially wide discounts – do not

happen accidentally and arise following a prolonged period of the

share price suffering more sellers than buyers. This, in turn, would

generally happen perhaps because the trust was a fairly consistent

underperformer or was in an unfashionable sector, or both.

In any of the latter circumstances it might be considered that the

share price might continue to underperform.

In summary, and before looking closer at other aspects of investment

trust companies in my next article, I must again highlight that the

undoubted usefulness of all of these indicators or ratios must be

tempered by the limitations I have already discussed – in particular,

the fact that they are an historical summary rather than an attempt

to provide an indication of future performance.

Keith Popplewell is managing director of Professional Briefing

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