More Valuation Methods – Lesson 4

Invested Capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent and you should look for a percent that approximates the level of growth that you expect. In its simplest definition, this ratio measures the investment return that management is able to get for its capital. The higher the number, the better the return.

To compute the ratio, take the pro forma net income (same one used in the EPS figure mentioned above) and divide it by the invested capital. Invested capital can be estimated by adding together the stockholders equity, the total long and short term debt and accounts payable, and then subtracting accounts receivable and cash (all of these numbers can be found on the company’s latest quarterly balance sheet). This ratio is much more useful when you compare it to other companies that you are valuing.

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Return on Assets (ROA). Similar to ROIC, ROA, expressed as a percent, measures the company’s ability to make money from its assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because of very common irregularities in balance sheets (due to things like Goodwill, write-offs, discontinuations, etc.) this ratio is not always a good indicator of the company’s potential. If the ratio is higher or lower than you expected, be sure to look closely at the assets to see what could be over or understating the figure.

Price to Sales (P/S). This figure is useful because it compares the current stock price to the annual sales. In other words, it tells you how much the stock costs per dollar of sales earned. To compute it, take the current stock price divided by the annual sales per share. The annual sales per share should be calculated by taking the net sales for the last four quarters divided by the fully diluted shares outstanding (both of these figures can be found by looking at the press releases or quarterly reports). The price to sales ratio is useful, but it does not take into account any debt the company has. For example, if a company is heavily financed by debt instead of equity, then the sales per share will seem high (the P/S will be lower). All things equal, a lower P/S ratio is better. However, this ratio is best looked at when comparing more than one company.

Market Cap. Market Cap, which is short for Market Capitalization, is the value of all of the company’s stock. To measure it, multiply the current stock price by the fully diluted shares outstanding. Remember, the market cap is only the value of the stock. To get a more complete picture, you’ll want to look at the Enterprise Value.

Enterprise Value (EV). Enterprise Value is equal to the total value of the company, as it is trading for on the stock market. To compute it, add the market cap (see above) and the total net debt of the company. The total net debt is equal to total long and short term debt plus accounts payable, minus accounts receivable, minus cash. The Enterprise Value is the best approximation of what a company is worth at any point in time because it takes into account the actual stock price instead of balance sheet prices. When analysts say that a company is a “billion-dollar” company, they are often referring to its total enterprise value. Enterprise Value fluctuates rapidly based on stock price changes.

EV to Sales. This ratio measures the total company value as compared to its annual sales. A high ratio means that the company’s value is much more than its sales. To compute it, divide the EV by the net sales for the last four quarters. This ratio is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times. For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant. However, by applying a EV to Sales ratio, you could compute what that company could trade for when its restructuring is over and its earnings are back to normal.

EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company’s cash flow and is used for valuing both public and private companies. To compute EBITDA, use a company’s income statement, take the net income and then add back interest, taxes, depreciation, amortization and any other non-cash or one-time charges. This leaves you with a number that approximates how much cash the company is producing. EBITDA is a very popular figure because it can easily be compared across companies, even if all of the companies are not profitable.

EV to EBITDA. This is perhaps one of the best measurements of whether or not a company is cheap or expensive.  To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the more expensive the company is. However, remember that more expensive companies are often valued higher because they are growing faster or because they are a higher quality company. With that said, the best way to use EV/EBITDA is to compare it to that of other similar companies.

Approximate valuation approaches – Lesson 5