(a) Free float

The free float is the proportion of shares available to purely financial investors, to buy when the price looks low and sell when it looks high. Free float does not include shares that are kept for other reasons, i.e. control, sentimental attachment or “buy and hold” strategies.

Loyalty is (unfortunately) not a financial concept and a skyrocketing share price could make sellers out of loyal shareholders, thus widening the free float.

Free float can be measured either in millions of euros or in percentage of total shares.

(b) Volumes

Liquidity is also measured in terms of volumes traded daily. Here again, absolute value is the measure of liquidity, as a major institutional investor will first try to determine how long it will take to buy (or sell) the amount it has targeted. But volumes must also be expressed in terms of percentage of the total number of shares and even as a percentage of free float.

(a) The principle

Investors interested in estimating the market value of a company’s capital employed frequently find that the stock market believes that a fair value for similar companies could be, for example, eight times their EBIT (or operating profit). With a pinch of salt, the investor can then decide to apply the same multiple to the EBIT of the company he is considering.

Investors name this ratio the EBIT multiple:

Enterprise value is normally estimated by summing the market value of equity and the book value of net debt, assuming that the difference between the book value of debt and the corresponding market value is rarely enormous.

Where the comparison is made using companies with different fiscal positions (because they belong to different countries, for example), it is more appropriate to consider an operating profit net of taxes (net operating profit after tax, or NOPAT). This result can easily be obtained by multiplying the operating profit by (1 – the corporate tax rate of the specific country).

A company whose value is 100 with an operating profit of 12.5 will be traded for 8× its operating profit. If the operating profit remains unchanged, and disregarding the terminal value, these figures imply that investors must wait eight years before they can recover their investment. Conversely, if the operating profit increases, they will not have to wait so long.

The following interpretation is consequently allowed: the EBIT multiple corresponds to the purchase price of €1 of the operating profit.

In practice, when applying the multiple, financial analysts prefer using the operating profit of the current period or of the next period.

(b) The multiple drivers

Although the EBIT multiple is a ratio that summarises a lot of information, its value is basically determined by three factors: the growth rate of the operating profit, the risk of capital employed and the level of interest rates.

1. The growth rate of the operating profit. There is a certain degree of correlation between the multiple and the expected growth of the operating profit. This is no surprise. Investors will be more willing to pay a higher price if the operating profit is expected to grow at a high rate (as long as the firm creates value, i.e. the investments generate a sufficient return). They are now buying with a high EBIT multiple based on current operating profit but with a more reasonable EBIT multiple based on future operating profit that is expected to be much higher.

   The reverse is also true: investors will not be ready to pay a high EBIT multiple for a company, the operating profit of which is expected to remain stable or increase slowly. Hence the low multiples for companies with low growth prospects.

   The reader should also not forget that behind the growth of the operating profit is the growth of both revenues and operating margins.

1. The following graph shows the relation between the medium-term growth rate of the operating profit of some European companies and their multiples.

2. The risk of the capital employed. The link between growth rate and multiples is not always verified in the market. Sometimes some companies show a low multiple and a high growth rate, and vice versa.

   This apparent anomaly can often be explained by considering the risk profile of the company. Analysts and investors in fact do not take the expected growth rate for granted. Thus, they tend to counterweight the effects of the growth rate with the robustness of these estimates.

3. The level of interest rates. There is a strong inverse correlation between the level of interest rates and the EBIT multiple. This link is rather intuitive: our reader is, in fact, perfectly aware that high interest rates increase the returns expected by investors (think, for example, about the CAPM equation!), thus reducing the value of any asset.

Generally speaking, we can say that the level of the multiple can be frequently explained – at a specific moment – by the current level of interest rates in the economy.

The EBIT multiple allows us to assess the company valuation compared to the overall market.

(a) The principle

Even if the EBIT multiple has become very popular in the investor and analyst community, a ratio simpler to compute has been used for a while to determine share prices. The P/E (price/earnings ratio), which, when multiplied by the earnings per share (EPS), provides an estimate for the value of the share.

P/E is equal to:

Another way to put this is to consider the aggregate values:

EPS reflects theoretical value creation over a period of one year. Unlike a dividend, EPS is not a revenue stream.

As an illustration, the following table shows the P/E ratios of the main markets since 1990. We can see the impact of the 2000 bubble on P/Es for TMT groups but also the impact of the 2009/2010 crisis with a fall due to the reversal of growth prospects, followed by a jump in 2010 due to poor earnings.

While there is no obligation to do so, P/E is based on estimated earnings for the current year. However, forward earnings are also considered; for example, N +1 expresses the current market value of the stock vs. estimated earnings for the following year. For fast-growing companies or companies that are currently losing money, P/E _{N +1} or P/E _{N +2} are sometimes used, either to give a more representative figure (and thus avoid scaring the investor!) or because, in the case of loss-making companies, it is impossible to calculate P/E for year N.

The widespread use of P/E (which is implicitly assumed to be constant over time) to determine equity value has given rise to the myth of EPS as a financial criterion to assess a company’s financial strategy. Such a decision might or might not be taken on the basis of its positive or negative impact on EPS. This is why P/E is so important, but it also has its limits, as we will demonstrate in Chapters 26, 27 and in Section IV.

HISTORICAL P/E RATIOS – PAN-EUROPEAN SECTORS (AS OF JANUARY 1ST)

P/E is conceptually similar to the EBIT multiple, and even more so to the NOPAT multiple. The latter is a division of enterprise value by after-tax operating profit, while P/E is a division of market value by net profit.

Hence, many of the things we have said about the EBIT multiple also apply to P/E:

• Another way of understanding P/E is to note that it expresses market value on the basis of the number of years of earnings that are being bought. Thus, an equity value of 100 and earnings of 12.5 means the P/E is 8. This means that if EPS remains constant, the investor will have to wait eight years to recover his investment, while ignoring the residual value of the investment after eight years, omitting the discount. If the EPS rises (falls), the investor will have to wait less (more) than eight years.
• In an efficient market, the greater the EPS growth, the higher the P/E and vice versa (on condition that the firm creates value, i.e. has a higher ROE than the rate of return required by shareholders).
• P/E is inversely proportional to interest rates: all other factors being equal, the higher the interest rates, the lower the P/Es and vice versa, again assuming efficient markets.
• The greater the perceived risk, the lower the P/E and vice versa.

P/E is used in the same way as the EBIT multiple. To value a company, it is useful to set it alongside other companies that are as comparable as possible in terms of activity, growth prospects and risk, and then apply their P/E to it.

P/E reflects a risk that the EBIT multiple does not – financial structure – which comes on top of the risk presented by the operating assets.

(b) P/E and investors’ required rate of return

Inverse P/E, also called earnings yield, is often mistakenly used in approximating investors’ required rate of return. This should only be done in those very rare cases where earnings growth is nil and the company pays out 100% of its earnings. Here is our reasoning:

Then:

and thus:

The P/E of a company with an EPS of 12 that is trading at 240 would then be:

The inverse P/E is just 5%, whereas the required return nowadays is probably about 8%.

All in all, the inverse P/E reflects only an immediate accounting return for a new shareholder who has bought the share for V and who has a claim on EPS:

• A very low return means that shareholders expect EPS growth to be strong enough to ultimately obtain a return commensurate with their required rate of return.
• A very high rate means that immediate return is uncertain and shareholders expect negative EPS growth to ultimately bring accounting return closer to their required rate of return.
• A normal rate, i.e. in line with the required rate of return, means that EPS growth is expected to be nil, and the investment is considered a perpetual annuity.

(a) Sales multiple

Sometimes the value of the firm is assessed in proportion to its sales, and the ratio enterprise value/sales is then computed. This ratio is often used to derive the value of shops or very small companies.

Using such multiples implies that the compared firms have the same type of margin. It implies somehow a normative return over sales for firms in a certain sector.

We believe that sales multiples should not be used for mid-sized or large companies as they completely disregard profitability. They have often been used in the past, in times of bull markets, to value Internet or biotech companies, for example, as such companies did not show a positive EBIT!

The same type of criticism can be levelled against multiples of numbers of subscribers, numbers of clicks, etc., or other multiples of volume of activity. These multiples not only assume a comparable return over sales but also the same revenue per unit.

(b) EBITDA multiple

In some sectors such as the telecoms sector, depreciation can be a very high proportion of costs (17% of Orange’s costs), and as depreciation periods and methods can be largely subjective (even for companies applying the same accounting principles), the profile of EBIT can be impacted and may not be comparable from one company to another. In addition, accounting principles can set different rules for depreciation and amortisation. In such cases, analysts and investors tend to compute EBITDA multiples instead of EBIT multiples.

Although we understand the logic of it, we do not recommend generalising this approach to all sectors. The use of the EBITDA multiple will lead to overvaluing low-margin companies and undervaluing high-margin companies.

(c) Free cash flow multiple

The free cash flow multiple is computed as enterprise value/free cash flow to the firm (i.e. EBITDA – theoretical tax on EBIT – change in working capital – capex). Free cash flow is, in fact, the sum that can be redistributed to the providers of the firm’s funds, therefore theoretically this multiple is highly relevant. It nevertheless suffers from its high volatility, in particular because the capex policy of the firm may show some huge differences from one year to another.

This ratio is therefore relevant mainly for mature sectors where capex is mainly maintenance capex. The reverse of this multiple is called free cash flow yield.

(d) Price to book ratio (PBR)

The PBR (price to book ratio) measures the ratio between market value and book value:

The PBR can be calculated either on a per share basis or for an entire company. Either way, the result is the same.

It may seem surprising to compare book value to market value, which, as we have seen, results from a company’s future cash flow. Even in the event of liquidation, equity value can be below book value (due, for example, to restructuring costs, accounting issues, etc.).

However, there is an economic link between book value and market value, as long as book value correctly reflects the market value of assets and liabilities.

It is not hard to show that a stock’s PBR will be above 1 if its market value is above book value, when the ROE is above the required rate of return (k _E). The reason for this is that if a company consistently achieves 15% ROE, and the shareholders require only 10%, then a book value of 100 would mean an equity value of 150, and the shareholders will have achieved their required rate of return:

However, the PBR will be below 1 if the ROE is below the required rate of return (k _E).

A sector cannot show equity value below book value for long, as sector consolidation will soon intervene and re-establish a balance, assuming that markets are efficient. Nor can a sector have equity value higher than book value for long, as new entrants will be attracted to the sector and bring down the abnormally high returns. Market equilibrium will thus have been re-established.

As an illustration, here are the PBRs seen on the main world markets since 1990:

PBR – PAN-EUROPEAN SECTORS (AS OF JANUARY 1ST)

(a) Free share awards

Suppose a company decides to double its equity by incorporating its reserves, and issues one new share for each existing share. Each shareholder is then the owner of twice as many shares without having paid additional funds and with no change to the company’s financial structure. The unit value of the shares has simply been divided into two.

Naturally, the company’s equity value will not change, as two shares will be equal to one previously existing share. However, the share price before and after the operation will have to be adjusted to obtain a comparable series.

In this case, simply divide the shares existing after the free share award by two. The adjustment coefficient is 1/2.

More generally, if new shares are issued for N already existing shares, then the adjustment coefficient is as follows:

(b) A rights issue with an exercise price below the current share price

This is the second reason we might have to adjust past per share data. We will go further into detail in Chapter 25, which deals with share offerings.

To subscribe to the new shares, investors must first buy one or more rights detached from previously existing shares, whose price is theoretically such that it doesn’t matter whether they buy previous existing shares or use the rights to buy new ones. The detachment of the right from the existing shares makes an adjustment necessary.

For a rights issue, the adjustment coefficient is:

If P is the price of the already existing share, E the issue price of the new shares, the number of new shares and N the number of already existing shares, then the adjustment coefficient will be equal to:

To make the adjustment, simply multiply all the share data (e.g. price, EPS, DPS, BV/S) before the detachment by this coefficient.

As you have seen, the adjustment consists in rewriting past stock performance to make it comparable to today and tomorrow, and not the reverse.