How do investors understand how to value a company before dedicating their money? Company news releases talk about their “net present value” (NPV), or “earnings per share” (EPS), but what do they mean and how are they calculated?
Here is a guide to understanding valuations and terminology to help ensure any investor can avoid overpaying for an investment.
Net present value (NPV)
When calculating how to value a company, a key metric to consider is a company’s NPV, the worth of a its net cash flow, minus its initial cash outflow.
NPV is an important metric because it weighs the value of time, considering that future cash flows can translate into money today. It also offers a solid number that management teams can use to compare the initial outlay of cash with the return’s present value.
Looking at an example of this in the small-cap spectrum we hear a lot about companies being “undervalued” or “overvalued.”
The metals and mining sector, specifically base or industrial metals, offers many options for investors looking for value who also need a way to protect themselves against inflation getting higher. To gather the best possible returns, here are a few things to keep in mind when gauging an opportunity:
- Look for a company that is in production, or the late stages of its construction.
- A project feasibility study filed in the past few years on SEDAR.
- Ideally it has funded its capital expenditures (CAPEX, or the funds used to acquire, upgrade, and maintain assets).
A problem that investors encounter with companies that have large NPVs is they also have capital expenditures (CAPEX) that are equally as large. Big CAPEX often means dilution which can take a big bite out of a share’s value.
Earnings per share (EPS)
A tool that investors often use to find a valuable company is to calculate its EPS, which is its profit divided by the outstanding shares of its common stock. If a company’s EPS is high, it could mean that it has considerable value.
For example, two promising companies report $1 million in earnings, but one has 1 million shares outstanding and the other has 2 million shares outstanding. The expectation is the company with 2 million outstanding shares would be priced at half of those compared with the other company, but if that company is selling its shares for much less, it might be considered a better investment, as the investor would be buying more earnings for every dollar.
If you look at a company’s shares like it were slices of a pie, you could see how two companies worth the same total amount of money could divide its shares. If Company A sliced itself eight ways at $100 a share and Company B sliced itself 16 ways, each Company B share would be worth half as much each.
This is important because different stocks can often appear hard to compare. For instance, if Company A trades at $10 a share and it made $100,000 last year, it would be hard to compare to Company B if it made only $50,000 last year, but its stock trades at $20 per share.
Determining the better value becomes more difficult because Company A could have 1,000 shares outstanding, which means it has an EPS of $10. On the other hand, Company B has 100 shares with $50,000 in income and yields an EPS of $50. Even though its stock price is twice as high, its EPS is five times as high and could be considered the better value.
Price-to-earnings (P/E) ratio
A company’s EPS, combined with its stock price, reveals its P/E ratio.
This is essential in comparing the value of stock shares between companies that earn different amounts of money and circulate different numbers of shares.
The P/E ratio measures a company’s current share price compared with its EPS and it’s the way investors determine a relative share value. It can be used to compare performance among companies in the same industry, used to judge performance based on historical record and pit aggregate markets against one another.
Price-to-earnings-growth (PEG) ratio
One flaw to the P/E ratio is that it will not determine a stock being “overvalued,” or if the company in question is only doing well at the time because traders are desperate for the business it is involved in.
The PEG ratio is a stock’s P/E ratio divided by the growth rate of its earnings over time. This can reveal a stock’s value and can also chart its expected earnings growth.
Investors now face more choices than ever, and it can be daunting for beginners and experienced traders to make sense of where the true value lies. It’s clear that proper stock valuation is a key component to any promising investment decision. When assessing any opportunity, evaluating its revenues (past, present and projected for the future), EBITDA, as well as NPV will help paint a clearer picture of what can be expected, especially when comparing any company with its peers.
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