Processing Knowledge

Newspapers and blogs highlight that the current market trends have jeopardized the enterprise value (EV) of many companies. Many investors spend sleepless night analyzing the annual reports of organizations to get a clear picture of the actual EV. Sector researchers and fund manager propose mathematical tools to predict this EV. So what exactly is this EV? For the common man the EV is the takeover price of organizations as it takes into account the cash
reserves.

Is the EV a good indication of the health of the organization?

The EV works for most of the organizations, however it might be misleading for a few sectors. There can be organizations that have a negative EV and yet be profitable. Such companies are exposing their
cash reserves for a penny. But are their cash reserves make such organizations a good buy? As pointed out in the blog by a KPO called S.G. Analytics,  the banking sector cannot be evaluated like other sectors. Further, the analysis done by SG Analytics shows that only in the Financial sector a significant number of companies (38) in East Asia, followed by 34 in North America (US) fall in the negative EV category. A simple research shows that a significant amount of cash is deposited at the central banks in the form of cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). However, in the current economic downturn the market capitalization of many financial institutions have shrunk and have become trivial compared to the total cash held by these banks.

Are analysts and KPOs of any help?

The cash reserves that make the stocks of such banks tempting may many a times be a mirage as the current economic downturn may spiral the good loans to go bad and might play a spoilsport by eating up most of the cash reserves. Thus, the moral of the story is predicting the EV of the banks is a non trivial task and should be better left to analysts and KPOs like SG Analytics.

A few days back I received a list of stocks that are currently having a negative enterprise value (EV) but a good forward earnings per share (EPS or P/E). I was a bit confused by this jargon and wanted to know what is the actual meaning of these terms. I came across this good post by a KPO regarding negative EV and why they are a good investment opportunity, however I was not sure about forward EPS as I was only aware of P/E, i.e., the price per earning.

The Price to Earning Ratio (P/E )

The price earning ratio is, as the name suggests, P/E where P = Price Per Share and E is the annual Earnings per share. Thus, as the units of P/E is the number of years, the P/E ratio is a nice indicator of the number of years of earnings that are required to get the purchase price of the stock. The component P is the value of the stock price while buying the stock however financial analysts such as S.G Analytics have various ways of computing E. The traditional value of E is computed as the earnings per share for the recent 12 months period.
For e.g. if the stock price of a company is $10 and the earnings (dividends) over the recent 12 month period is $1, then the P/E = 10/1 = 10 years.

How to identify companies that performed badly last year but have good prospects this year?

The P/E is a good indication of the past performance of the company however given the current economic scenario it is not a good indicator of which stocks have a potential to perform well. There are metrics like the T-Model, that take into account the growth rate but computing such metrics is better left to the financial analysts and fund managers. However a simple metric that can take into account the growth is by using the potential earnings per share given the growth potential of the sector. This is exactly what is done while computing the forward EPS. In case of forward EPS, the expected earnings per share is the E in the P/E ratio. Thus, the forward EPS is many a times referred to as the estimated price to earnings by financial analysts.

A word of caution

Over the years a stock’s P/E is used as a good indication of how much investors are willing to pay per dollar of earnings. As the P/E takes into account the earnings per share it gives a much better indicator of a stock’s value than the market price alone. However, there are many reasons for a forward EPS to be high/low which are many a times heavily dependent on the market sentiments.