PE ratio

[winner69]

For whats itworth I don't worry that much about ROA or ROE but see ROIC (return on invested capital) as more meaningful

ROIC = Operating Profit / (Equity + Debt) expressed as a %age.

Academics are more complicated but Operating Profit can be expressed as EBIT - Notional Tax (at company tax rate X EBIT)

If ROIC is greater than the company's cost of capital it is adding economic value / less it it is destroying value

This way one is getting a real return on all the capital invested - whether it comes from shareholders or bankers

[Snoopy]

I alluded to the "magic formula" from __The Little Book that Beats The Market__.

It comprises two steps.

First, <snip>

then rank on:

Earnings yield = EBIT/Enterprise Value

[EV = price + interest bearing debt]

The idea behind using these measures rather than simpler P/E is to eliminate the effects of gearing, taxation and intangibles.

From "www.investorwords.com", another Definition

--------

enterprise value

A measure of what the market believes a company's ongoing operations are worth. Enterprise value is equal to (company's market capitalization - cash and cash equivalents + preferred stock + debt). The number is of importance both to individual investors and potential acquirers considering a takeover attempt.

---------

'earnings yield' is, more crudely than you put it, E/P rather than P/E. But I take your point that the comparison is valid provided we all remember that a high E/P is equivalent to a low P/E.

I understand why the alternative 'earnings yield'

Earnings yield = EBIT/[market capitalisation + interest bearing debt]

is important if you want to take over a company. After all, the return you will get on your investment will be maximised if you:

1/ buy all of the shares
2/ AND pay off any existing company debt

But why should your 'Earnings Yield' be of concern to small shareholders? If we buy shares in a company, we cannot force the company to pay off any debt. We cannot force the company to pay less tax either.

So why not just use E/P?, or (Net Profit/Market Capitalisation)

Both my 'E/P' and your 'Earnings Yield' take debt into account. The only difference is that I take the annual impost of the debt, the interest payable, off the top line hence reducing E/P accordingly. You put the total amount of debt in the bottom line and that reduces your 'Earnings Yield' accordingly.

I take tax paid into account using E/P. You do not using your 'Earnings Yield'. But my taking tax into account is not going to change the ranking of shares we compare, because the tax payable is a fixed proportion of any gross income. Thus taking the same proportion off a comparative list of gross incomes will not change any rankings list one bit.

Perhaps I have missed something. But right now I can't conceive of any circumstance when ranking companies by my E/P (or P/E) will select different shares than you ranking the same companies by 'Earnings Yield' EBIT/[market capitalisation + interest bearing debt]. Am I missing something?

SNOOPY

[stephen]

Snoopy, as I said earlier, why not read the book, which is easily obtainable?

But briefly, my understanding is:

- comparing things without the effect of tax prevents us from accidentally including companies which are carrying forward past tax losses. (Don't forget this is a screening tool, based purely on last years figures, so it's nice to make it a little more discriminating).
- the idea behind removing gearing effects is to see how well the company can use a dollar, no matter how obtained.
- I quote here: "Enterprise value was used instead of merely the __price__ of equity because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings... [big snip] ... in other words, P/E is greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not."

Re EV, the book doesn't say this, but I would have said the small investor should look at EV, because while I can't take over a company, I will likely enjoy a substantial benefit if a bigger investor decides to. As a value investor, relying on other people to reprice an underpriced asset, this is a critical figure for for those other people.

Personally, I don't think there's going to be a huge discrepancy between the selections produced by screening with the "magic formula" and, say, using ROA and PE as screens. But I'm interested to get some ASX data for the All Ords and see for myself.

I'm also thinking that the NZX is too small for a broad screening strategy to work that well.

[steve fleming]

I understand why the alternative 'earnings yield'

Earnings yield = EBIT/[market capitalisation + interest bearing debt]

is important if you want to take over a company. After all, the return you will get on your investment will be maximised if you:

1/ buy all of the shares
2/ AND pay off any existing company debt


SNOOPY

Snoopy, maybe you are getting a bit confused here.

A takeover valuation is VERY different from an Enterprise value.

A takeover valuation incorporates such things as premium for control and the impact of cost savings and synergies etc - all of which are definitely not reflected in the Enterprise value.

Very simply, SURPLUS ASSETS + ENTERPRISE VALUE = DEBT + EQUITY VALUE.

You can calculate the equity value from an Enterprise value and vice versa.

In practice you will find the EV/EBIT & EV/EBITDA approach used in assesing value far more often than the P/E approach, for the reasons Stephen outlined.

[_Michael]

Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

[steve fleming]

Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

Thats a great tool

http://www.afrsmartinvestor.com.au/tables.aspx

cheers

[OldRider]

Michael:

A great site. The CSV format of so much information will allow quick comparisons,
something that has been time consuming previously.

Mythanks, I thought I had a fair knowlege of ASX internet sites, but this one had escaped me completely.

[steve fleming]

Steve

With regards to free financial data on ASX stocks - check out the AFR Smart Investor website - they update an excel spreadsheet weekly with every stock on the ASX it includes quite a lot of data including book value, p/e, etc and you can download it and add in your own formulas calculations as required. Its a great tool for initial screening when looking for value stocks in particular. It also has sector / industry so you can make you own version just filter out your unwanted sectors.

cheers
Michael

BTW

_Michael = Flying Goat???

or am i way off the mark?

[Snoopy]

Briefly, my understanding is:

- comparing things without the effect of tax prevents us from accidentally including companies which are carrying forward past tax losses. (Don't forget this is a screening tool, based purely on last years figures, so it's nice to make it a little more discriminating).

Ah very good point Stephen. Last time I bought into a company with tax losses it was so long ago that I can't remember what it was! You tend to forget about shares that are a long way off your own 'radar screen of comfort'.

Nevertheless declaring a dividend when you have tax losses is 'bad' for the shareholder in the sense that the shareholder still has to pay tax even though the dividend paying company doesn't. So by my thinking, the amount of tax the company has to pay (or not) *is* relevant to the small shareholder (carried forward tax losses being a bad thing). So taxes losses 'on the books' should be considered.

Often tax losses *are* important over many years (not just 'last year') because the situation of a large one off loss that takes many years to recover from is not that unusual in the world of commerce.

- the idea behind removing gearing effects is to see how well the company can use a dollar, no matter how obtained.
- I quote here: "Enterprise value was used instead of merely the __price__ of equity because enterprise value takes into account both the price paid for an equity stake in a business as well as the debt financing used by a company to help generate operating earnings... [big snip] ... in other words, P/E is greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not."

Yes I see what you mean, although this is really another version of the ROE verses ROA argument.

I think there is a natural tendency to regard debt within a company we invest in as 'bad'. I actually regard company debt as good if the company is geared up enough to keep predators at bay. That means the company executives can concentrate on what they should be doing: running the business instead of always fending off offers from suitors.

Re EV, the book doesn't say this, but I would have said the small investor should look at EV, because while I can't take over a company, I will likely enjoy a substantial benefit if a bigger investor decides to. As a value investor, relying on other people to reprice an underpriced asset, this is a critical figure for for those other people.

Yes you have a point there, although I still regard with some contempt the investor who has no vision of their own and regards 'selling out' to someone bigger as the only way to get rich. I would never invest in a share solely because I think it *might* be taken over. As it happens I always seem to be fending off takeover offers. But that is because the suitors saw the same fundamental value in the company that I did, not because I bought 'hopeing' to be bought out. Personally I feel being 'bought out' is rather annoying because it forces me to do a whole lot more homework before I decide when I should reinvest the money

SNOOPY

[_Michael]

Hi Steve

Yep - my username was FG but when the new site came online i could not get in under my old sign in and no longer had my original woosh email address so had to create a new one...!