So, onto the nitty gritty, whether a company is a buy, hold or a sell.

Let us consider a house for sale. Wearing our “stock market investing” hat, we would look at how much we could receive from rent less costs such as council rates, body corporate, insurance (BUT ignoring interest, tax, and depreciation for the moment). We compare what we would get, let’s call it “net rental”, with the sale price of the house. Obviously the sale price is going to be some multiple X of the net rental. We then compare sale values of other similar houses in the street to their net rentals. For example, if the house next door was sold recently for $200,000 and had net rentals (rent less costs) of $20,000, the sale value is about 10 times the net rental. So if your house only makes net rentals of $15,000, as a guide the value of your house would be 10 times this or $150,000. This is the exact approach we take in valuing shares.

Let us consider a port company as an example. Port Ashley earned $100 million in revenues and expensed $40 million in labour and materials and admin costs in 2006. Its earnings before interest, tax, depreciation, and amortisation (or EBITDA, also called its “gross operating margin”) is thus $60 million for the year. We now look at similar ports operating around the ENTIRE world to see what multiple of EBITDA the Port Ashley business ought to be sold for on average (basically a broker’s full research report should have this). Let’s suppose the average multiple is 12 times. Then the value of the port business, called the Enterprise Value or EV “should eventually be in a rational world” 12 * $60 million = $720 million, where 12 is the EV/EBITDA multiple or ratio.

As with a home owner, a shareholder doesn’t necessarily have an economic interest in ALL of the business – if the business has debt/mortgages, then the bank does! To work out the equity value, all you do (as every home owner knows) is subtract the amount of debt from the total value of the home/business. Thus if Port Ashley had $330 million of debt and $10 million of cash (according to the 2006 financial statements), then the value of equity “should eventually be in a rational world” $720M - $330M + $10M = $400 million. And if there were 200 million shares on issue, the (equity) value per Port Ashley shares is just $400 million divided by 200 million shares = $2.00 per share. Of course the actual share price may be below or above this estimate of value at any given time!

Another way of looking at this is suppose Port Ashley shares were actually trading on the stock market at $1.50 per share. The actual equity value is thus 200 million shares * $1.50 = $300 million. We now add debt (and subtract any cash) to get Port Ashley’s enterprise value. $300M + $330M debt – $10M cash = $620 million enterprise value. As EBITDA is $60 million, the EV/EBITDA ratio is $620M/$60M = 10.3 times. This is less than the global average of 12.0 times, so could be considered “undervalued” at first glance. (Of course there could be lots of circumstances which may make this fair or even overvalued – we will consider these in future lessons.)