Dividends are usually periodic cash payments to shareholders out of a company’s earnings or earnings reserve.

In corporate finance theory, the total returns you get from investing in a share = Income Return + Capital Return

where Income Return is your dividend component, while Capital Return is the increase in value of your share price. Therefore

Share Investment Return = (Dividend per Share + Change in Share Price) / Purchase Price

For example, if you bought Petronas Dagangan (PETDAG) at RM8.45 on 10-Aug-07 with the expectation that you will receive 30 sen in dividends over the coming year and that the share price will grow to RM9.50, your projected return is:

(0.30 + 1.05) / 8.45 = 16%

Your expected Dividend Yield (or Income Return) is 3.6% while your expected Capital Return is 12.4%.

You can then compare this with other alternative investments such as Fixed Deposit or other shares/bonds, and make an evaluation whether this is an acceptable return taking into account the associated investment risks.

Note

1. Share Investment Return calculation is a projected or forecast figure.
2. Dividend Yield calculation excludes Special Dividends

PEG Ratio = PER / Annual EPS Growth

PEG is a widely used indicator of a stock’s potential value. It is favored by many over the price/earnings ratio because it also accounts for growth.

Similar to the P/E ratio:
The lower the PEG Ratio, the more undervalued the stock is and the greater the bargain you are getting.

As a Rule of Thumb, a PEG Ratio of less than 1 is considered good. For example, if a stock is trading at a PE Ratio of 12 times and it’s expected Net Profit growth is 15%, its PEG Ratio works out to be 0.8 and this is generally considered favourable.

Keep in mind that the growth rate used is projected and may not be accurate. Also some investors look at growth rate for several years before deciding on a growth rate to use in the PEG Ratio calculation.

(EBIT stands for Earnings Before Interest and Tax. It is the profits of the company before the impact of interest income, interest expense and tax expense. As such it is an indicator of the earnings of a business excluding the impact of its cash holdings and borrowings).

Calculation of EBIT
Our calculation approach for EBIT is as follows:
EBIT = Profit Before Tax – Interest Income + Finance Cost – Abnormal / Extraordinary / Unusual Items.

Note: EBIT should equal the company’s stated Profit From Operations plus its share of income from Jointly Controlled Entities and Associates, less Interest Income (if it has included this in its Profit From Operations).

Why Look at EBIT?
By understanding the true EBIT of a business, we are in a better position to form a view of the underlying earnings of the business and hence its business value.

Enterprise Value
Enterprise Value is basically the value of a company excluding its cash and debt position. See explanation here.

Using EV/EBIT
EV/EBIT is also known as EBIT Multiple. This is an extremely useful indicator and like PE Ratio, it shows how many times a share price trades against earnings.

The difference between EBIT Multiple and PE Ratio is that EBIT Multiple takes into account distortions in earnings caused by cash holdings and borrowings, while PE Ratio just lumps in everything.

If we were to use just the PE Ratio to measure a company’s valuation, we may overlook the true income generating power of its underlying business.

Example: UAC Berhad
UAC is listed on Bursa Malaysia under the Industrial Products sector. It manufactures fibre cement products and other building materials for the property and construction industries. For the last 2 years, UAC’s financial profile can be summarized as follows:

At the time of writing 4 August 2007, UAC’s share price is RM4.70 and it has 74.3 million issued shares, giving it a Market Cap of around RM349 million.

Earnings Per Share for the year ending 31-Dec-2006 was 41.6 sen, meaning that it is trading at 11.3 times earnings. This does not look excitingly cheap at face value.

However look at UAC’s balance sheet more closely and you will see that they have cash holdings of some RM177 million and no borrowings. If we were to exclude the impact of these cash holdings, we would see something like this:

EBIT = RM35.5 million
Enterprise Value = RM(349 – 177) million = RM172 million

EBIT Multiple = 4.8 times

What this means in theory is that we can buy the entire company at RM349 million and the company we buy has some RM177 million cash which we can draw out completely, implying that the net price we are paying for the business assets is only RM172 million. This RM172 million that we fork out should return us earnings of around RM35.5 million or around 21% return on capital. Now that starts to look a bit better!

Compare this approach to just looking at PE Ratio. Under the PE Ratio approach, you would be looking at Net Profit After Tax of RM30.9 million divided by Market Cap of RM349 million, ie a return of only 8.9% on your capital. This low return is distorted by the company’s excessive cash holding (which you can assume earns a minimal 3-4% return). Strip out this cash and all of a sudden your PE Ratio will come down to below 5 times. So the business assets looks a lot cheaper indeed!

EBITDA Multiple
EBITDA Multiple = EV / EBITDA

(EBITDA is Earnings before the impact of interest income, interest expense, tax expense, depreciation expense and amortization expense)

A commonly used variant is the EV/EBITDA ratio which also excludes the impact of depreciation and amortization expenses incurred by the company, on the basis that these are non-cash expenses.

Accounting policies require that Property, Plant and Equipment are to be depreciated over a finite life. Due to the nature of certain types of assets, such a policy is sometimes considered conservative because the equipment in question may last well beyond the depreciation period, meaning that this equipment can continue to be used to generate business income for an indefinite period (perhaps with a little maintenance). Likewise accounting policies require that intangible assets such as goodwill or intellectual property be amortized over a finite life, while the actual reality is that the value of such intangibles may well increase over time because management successfully utilizes such assets to increase business earnings over time. Therefore under certain scenarios you may also wish to look at EBITDA Multiple to assess whether a company is cheap or expensive.

Where Earnings per share (EPS) is a company’s Net Profit After Tax and Outside Equity Interest, divided by the Weighted Average Equivalent Number of Shares issued.

For example if a company makes a net profit after tax of RM10 million and it has 100 million issued shares, its EPS would be RM0.10. If its share price is RM1.20, the PE ratio is 12x, meaning that the share price is trading at 12 times its earnings.

PE Ratio is commonly used as a rule of thumb to determine whether or not a company’s shares are reasonably priced by the market. Smaller companies on Bursa Malaysia are typically valued at PE Ratios of between 7 to 12 times earnings per share, while larger caps typically command PE Ratios of 12 to 15 times earnings per share.

Note: There are several variants to this calculation including Diluted PE Ratio and PE Ratio before Abnormal/Exceptional/Unusual/Extraordinary Items.

PE Ratio Normalized
This is the PE Ratio of the share before the impact of Abnormal, Exceptional, Unusual and Extraordinary Items. Such items typically include:

• One-off gains & losses (items not in the normal course of business)
• Items which are unusually large, even though they are in the normal course of business
• Property revaluations in the case of REITs

PE Ratio Normalised is the Share Price divided by the Adjusted EPS.

In our calculation, we take the Net Profit After Tax and deduct Abnormal, Exceptional, Unusual and Extraordinary Items. This gives us the Adjusted Net Profit. We then take this figure and divide by the Weighted Average Equivalent No of Shares to arrive at the Adjusted EPS.

This is a quick and useful way to get a feel for a company’s value. For example, if a company’s NTA is RM1.50 and its share price is RM3.00, it implies a company’s share price is trading at twice its tangible book value.

This in itself is quite meaningless because most good companies have undervalued assets due to accounting conservatism.

However it is a useful indicator when benchmarking against industry peers. For example if you follow the banking sector and find that the average NTA multiple is around 2.3x and if a banking stock became available at 1.6x NTA, you would become excited and perhaps look at it more closely.

It is a measure of the value of a company’s businesses excluding the cash holdings and financial debt of the company. If a company has more cash than borrowings, then its EV will be Market Cap less the net cash position.

Why Do We Have to Look at EV and not just Market Cap?
EV is basically the value of a company excluding its cash and debt position. When buying a business, we need to consider the value of its business assets and cash position separately. This is because cash can be valued dollar-for-dollar while business assets (such as plant & equipment, inventory and intangibles) are collectively valued depending on the future income it can generate.

Since we are buying business assets and systems to generate future income streams, therefore we need to properly appraise the value of the business without distortion from cash holdings and debt.

Note: Companies do not publish their cash / debt position every day. So EV is calculated using the latest available audited balance.

For example if a company has 100 million shares and its share price is RM5, its market cap is RM500 million. In theory the stock market is placing a value of RM500 million for that whole company.

Note: Appraising a company’s true value may become harder if there is a large number of derivative instruments (eg options/warrants) issued by a company.