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's 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
Thus, for example, a company's 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's profits could have changed dramatically for better or worse.
Perhaps even more misleading, the price/earnings multiple compares
the company's profitability for the last full accounting period (this
could be over one year old) with the company's 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's assessment of the trading environment in which the
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's net asset value (NAV).
This can be defined simply as the value of the company's 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's 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's 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
This is unlikely in our example as the company's 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's assessment that the company's 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
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's 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
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's 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
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
In my last article I started to look at formulae and comparisons from