Analysis & Opinion


11 shares where positive earnings shocks could trigger rallies
Wed, 26th April 2017 - 13:41

Companies that beat profit forecasts tend to rally over the next few months, so Stockopedia's Ben Hobson reveals the biggest recent surprises on the FTSE 350 and AIM.

How Royal Bank of Scotland shares could double
Wed, 26th April 2017 - 10:13

Royal Bank of Scotland is poised to move quickly and the trend is 'common sense', says Alistair Strang. But there are bigger targets on the chartist's radar.

Share Sleuth: A valuation measure investors can trust
Wed, 26th April 2017 - 08:46
Look at the whole business, including debt, for a clearer view of valuation, advises Richard Beddard.
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 fi rms. 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.
Since the value of equity (market capitalisation) and profit determine the standard earnings yield and p/e ratio, the company's valuation is determined partly by how it's financed. But if a company were to change the way it's financed, we wouldn't expect the value of the firm or of the shares we own in it to change, any more than we'd expect the value of a house to rise just because we remortgaged.
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.
This article was originally published in our sister magazine Money Observer. Click here to subscribe.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Look at the whole business, including debt, for a clearer view of valuation, advises Richard Beddard.

Carpetright rally meets sticky end
Tue, 25th April 2017 - 14:22

Admitting it didn't make as much last year as many thought, Carpetright shares have plunged. Lee Wild analyses the chances of a swift recovery.

Company News

Here's why Virgin Money trumps Metro Bank
Wed, 26th April 2017 - 17:02

Challenger banks Metro Bank and Virgin Money both continued impressive growth in the first quarter, but one analyst sees more value in the latter, reports David Brenchley.

Surging Standard Chartered defies the doubters
Wed, 26th April 2017 - 14:27

The banking blue-chip rose 5% Wednesday on first-quarter results, but there are plenty of question marks here, writes David Brenchley.

These two Winter Portfolio stars rally again
Wed, 26th April 2017 - 12:59

They were doing great already, but two of the most reliable stocks in our Consistent Winter Portfolio have risen sharply again. Lee Wild reports.

The Oil Man: Rockhopper, IGas, Falcon Oil & Gas, Ascent Resources
Wed, 26th April 2017 - 11:16

Oil industry analyst Malcolm Graham-Wood has seen it all. He gives Interactive Investor his opinion on the sector's top stories.

Breaking Market News

Updated: 50 min 34 sec ago

A bounce back in oil prices boosted oil giant BP (BP.) by 1% and helped the FTSE gain positive momentum after subdued trading.

Brent crude oil was up 0.4% to $52.29, while West Texas...