Share Sleuth: A valuation measure investors can trust

In my last column I explained how I judge whether a share is overvalued or undervalued. The basic earnings yield calculation I described is earnings (profit for the most recent financial year) divided by market capitalisation (the price of all the shares with a claim on the profit) and expressed as a percentage.

It's a measure of return on investment, and the reciprocal of the venerable price earnings ratio (price divided by earnings). If the earnings yield is, say, 5%, we're paying more than 20 times earnings for the shares, too much for all but the very best firms. While good companies are likely to grow and over time yield more, there are limits to how much it is wise to pay. I don't use this simple version of the earnings yield though; my version accounts for how companies are financed.

Companies are financed in different ways - some have debt while others do not, some lease their premises or equipment (which is a kind of borrowing) and others own them outright, and some have not paid sufficient money into their pension schemes to meet their obligations, which means they have run up a debt to current and past employees.

Rather than use a company's market capitalisation, which only measures the market value of the firm's equity, I add all these forms of debt to the market capitalisation, to produce a figure known as enterprise value. It's a measure of the value of the whole business, in the same way as the market value of a £500,000 house is the value of the equity : the £100,000, say, of your own money used to purchase it, and the £400,000 you borrowed when you mortgaged the property.

Since we have changed the denominator of the earnings yield calculation to include all the debt in the market value, or price, of the company (as though we are paying it off), we do not include the cost of that debt (i.e. the interest) in the numerator, profit. The adjusted profit measure is expressed as a percentage of the enterprise value to calculate the earnings yield.

Why value the whole business, rather than just the equity component?

When you buy shares, you buy the right to a proportionate share in the profit the enterprise subsequently earns. The profit is generated by the whole business, including those parts financed by debt. But debt distorts the returns on our investment as measured by the standard earnings yield calculation in two ways: it reduces the profit (the return) by the interest cost, and it reduces the investment (market value of equity) because a company relying on debt funding requires less equity funding.

By incorporating the value of debt into the purchase price of the company and ignoring the interest component of profit, we calculate a debt-free valuation as though we'd bought the company outright. It puts firms with differing amounts of debt on a more equal footing. It's better for us as long-term investors to base our valuations on the returns we might expect from the business itself, rather than arbitrary levels of leverage.

If that sounds complicated, you needn't worry much. Stick to companies that do not have much debt and the standard earnings yield or price/earnings ratio is a reasonable guide to valuation. If you prefer to value the enterprise and not just the equity, you can cheat. Software providers such as SharePad calculate 'Ebit' yields, a version of my earnings yield.