A share or stock is an investment that can only be sold for cash, and its returns are unpredictable. To offset these risks, shareholders gain influence over the company’s management through voting rights associated with their shares. This article will outline the main factors used in stock analysis and explain how the stock market works.

1. BASICS

This section covers the basics of stock valuation, whether listed or not. Here are the main concepts you’ll need to know before navigating into the concept of shares:

• The voting rights shares usually come with one voting right each. This voting right compensates for the investment risk rather than being a core feature of the stock itself. Companies may issue shares with limited or no voting rights, such as preference shares or non-voting shares. In some countries, multiple share types (e.g., “A” shares, “B” shares) with varying voting rights may be issued to consolidate control.
• The earnings per share (EPS) is calculated by dividing net profit attributable to shareholders by the total number of shares. It reflects the value created for the year. EPS can be adjusted for exceptional items or goodwill amortization.
• The dividends per share (DPS) are usually paid from net earnings but can also come from retained earnings. They may be distributed quarterly or semi-annually.
• The dividend yield is the ratio of the most recent dividend to the current share price. For example, the average dividend yield on Western stock markets is about 3%. Here is the formula:

• The payout ratio is the percentage of earnings distributed as dividends, calculated by dividing dividends by net income. A ratio above 100% indicates the company is using reserves, while a ratio close to 0% suggests reinvestment of earnings. In 2011, European companies had an average payout ratio of about 43%. Higher payout ratios may lead to slower earnings growth due to reduced reinvestment.
• Equity value (book value or net asset value) per share reflects the accounting estimate of a share’s value based on shareholders’ investments (new shares issued and retained earnings). It can differ from book value, which is often adjusted for financial institutions and holding companies.
• Cost of equity (expected rate of return), according to the CAPM, is the risk-free rate plus a risk premium based on market risk:

• Shareholder Return (Historical Rate of Return) includes dividends (dividend yield) and capital gains. Total shareholder return (TSR) reflects the internal rate of return (IRR) over a period.
• Liquidity; A stock is considered liquid if it can be bought or sold in large quantities without significantly affecting its price. Liquidity is measured by free float, trading volumes, and analyst coverage. Free float is the portion of shares available to investors, excluding those held for other reasons. Trading volumes and percentages of total shares or free float also assess liquidity.
• Market capitalization is the total value of a company’s shares, calculated by multiplying the share price by the total number of shares. It is often calculated using all shares, not just those in free float.

2. THE MULTIPLES

To assess stock prices, investors often compare them with similar investments, or comparable stocks. This comparison helps them determine the relative value of stocks based on their own evaluations of company quality and price levels. Typically, investors use financial metrics to make these comparisons. There are two main types of valuation multiples:

• Multiples for direct market capitalization estimates: These helps estimate a company’s market value directly. An example is the price-to-earnings (P/E) ratio.
• Multiples that exclude capital structure: These helps estimate the total value of the firm or the market value of the capital employed, without considering how the firm is financed. The EBIT multiple falls into this category. Since capital employed is funded by both equity and net debt, the total enterprise value must be divided between creditors and shareholders. The following formula illustrates how to derive equity value from enterprise value: Enterprise value = Value of net debt + Value of equity and Value of equity = Enterprise value − Value of net debt

EBIT Multiple

To gauge a company’s market value, investors often compare it to similar companies. For instance, if similar firms are valued at eight times their EBIT (operating profit), an investor might apply this multiple to their target company. This ratio, known as the EBIT multiple, is calculated as:

Enterprise value is typically the sum of the market value of equity and book value of net debt. For companies in different tax jurisdictions, it’s better to use net operating profit after tax (NOPAT), calculated by multiplying operating profit by (1 – tax rate).
If a company with a 12,5 operating profit is valued at 100, it implies an 8x multiple. If the profit stays the same, it would take eight years to recover the investment, but increased profit would shorten this period. The EBIT multiple is influenced by three main factors:

• Growth rate: Higher expected growth usually results in a higher multiple. Investors pay more for companies with strong growth prospects.
• Risk: Companies with higher risk tend to have lower multiples, even if they have high growth rates. Risk adjustments impact how much investors are willing to pay.
• Interest rates: There’s a strong inverse relationship between interest rates and the EBIT multiple. Higher interest rates lead to lower multiples as they increase the required returns on investments.

Overall, the EBIT multiple reflects a company’s value relative to the market and is affected by these key factors.

Price to earnings (P/E)

The P/E (Price-to-Earnings) ratio is a widely-used method to estimate share prices. It is calculated by dividing the price per share by earnings per share (EPS) or by dividing the company’s market capitalization by its net income.

EPS represents the theoretical value creation over one year, although it is not a direct revenue stream like dividends. It provides an estimate of how many years of earnings are being “purchased.” For example, if a company’s P/E is 8, an investor would expect to recover their investment in eight years, assuming constant earnings.

P/E ratios are often based on current-year earnings, but estimates for future years (P/E N+1, N+2) may be used, especially for companies with high growth or temporary losses. Like the EBIT multiple, P/E tends to increase with higher EPS growth and decrease with higher risks or interest rates.

The inverse of P/E, known as the earnings yield, is sometimes mistakenly used to estimate an investor’s required rate of return. However, this only holds true if the company is not growing and pays out all of its earnings as dividends. In most cases, inverse P/E underestimates the required return because companies are growing. Conversely, in rare cases, it might overestimate returns for mature companies. The earnings yield should not be relied on as a perfect measure of return, as it only reflects an immediate accounting return for new shareholders and not future growth potential.

3. OTHER MULTIPLES

Apart from the EBIT and P/E multiples, investors and analysts use other multiples as well.

Sales multiple

This ratio, enterprise value to sales, is sometimes used to value smaller firms or shops. It assumes that the compared companies have similar profitability and a standard return over sales in their industry. However, sales multiples ignore profitability and should not be used for larger firms. They were popular during bull markets for valuing companies like internet startups or biotech firms that had no positive EBIT. Similar criticisms apply to multiples based on subscriber counts, clicks, or other activity metrics, as they also assume comparable returns and revenue per unit.

EBITDA multiple

In sectors like telecoms, where depreciation can account for a large portion of costs, EBIT may not be a fair comparison due to varying depreciation methods. Analysts may use EBITDA multiples instead to avoid distortion. While useful in certain industries, generalizing EBITDA multiples across all sectors can lead to overvaluing low-margin companies and undervaluing high-margin ones.

Free cash flow multiple

This is calculated as enterprise value divided by free cash flow (EBITDA minus taxes, changes in working capital, and capital expenditures). Free cash flow reflects the money that can be returned to the firm’s financiers. While highly relevant in theory, this multiple can be volatile, particularly because capital expenditures can vary greatly from year to year. It’s most applicable in mature industries with stable capital expenditure patterns.

Price to book ratio (PBR)

The PBR compares market value to book value by dividing the price per share by the book value per share (or equivalently, market capitalization by the book value of equity). While there is no direct link between book value and market value, there is an economic relationship as long as book value reflects the market value of assets and liabilities. A PBR above 1 indicates that a company’s return on equity (ROE) exceeds the required rate of return. Conversely, a PBR below 1 suggests that ROE is below the required return, though market forces eventually balance these disparities through consolidation or new competition.

Stock valuation relies on various metrics to assess a company’s financial health and market performance. Investors use multiples like P/E, EBIT, and free cash flow to compare firms and estimate their value. Each multiple has its strengths and limitations, depending on factors such as profitability, risk, growth potential, and industry specifics. While these tools provide insight, they should be applied carefully, considering the unique characteristics of each company and sector.