Techniques to Determine the Value of an Investment
Besides all the calculations that a corporation can make concerning its value, earnings, liquidity, and so on, investors can use several techniques to determine whether it was profitable to invest in the company. These techniques include annual return, holding period return, simple rate of return, and dividend payout ratio.
The annual return per share and the annual rate of return for an investment analyze whether any increase or decrease occurred in the value of a stock and whether any dividends were distributed to stockholders. Assume that an investor purchased a stock on January 1, 2012, and sold it on December 31, 2012. The stock was purchased at $8 per share and was sold for $10 per share. During the year the company paid dividends of $0.04 per share. The annual return per share and annual rate of return would be calculated as follows:
annual return per share = increase or decrease
in value + dividends = ($10 − $8) + $0.04 = $2.04
annual rate of return = annual return /
initial investment= $2.04 / $8.00 = 25.5%
The 25.5% return highlights how profitable the investment in the stock was that year. But this analysis is useful only for a quick snapshot in time and only if the stock was sold. If the stock price fell the next day, then the annual return would still be an accurate reflection of the value for the prior year but would not reflect the true value of the investment. The relevant concept here is paper profit (because the profit is shown only on paper). That is, the stock might have produced an excellent annual return, but if the stock is not sold the profit could vanish in an instant if the stock price declines.
In contrast to annual return, the holding period return takes into consideration the fact that the stock was possibly not sold. For the stock being analyzed, the holding period return indicates what happened to the investment, independent of what might happen in the future. Because the return on the investment during the one-year holding period was 25.5%, that is the holding period return rate. The dividend payout ratio examines the dividends per share relative to how much the company earned per share. The formula is as follows:
dividend payout ratio = dividends per share /
earnings per share
If dividends per share are $0.50 and earnings per share are $3.00, the dividend payout ratio is 16.67 ($0.50 / $3.00). This number means that 16.67% of earnings were repaid to the stockowners as dividends.
To get a sense of how the stock market is valuing a company, we can compute the price–earnings ratio (PE ratio). The PE ratio is equal to the price per share of common stock divided by the earnings per share of common stock. Earnings per share (EPS) is calculated as follows:
earnings per share = net income /
average number of shares outstanding
If Speedway Motorsports (SM) and a competitor each reported earnings per share of $5, but SM’s shares sell for $15 and its competitor’s shares sell for $20, then the PE ratio for SM is 3 and its competitor’s PE ratio is 4.
price–earnings ratio = price per share /
earnings per share = $15 / $5 = 3
By contrast, the PE ratio for SM’s competitor is 4.
price–earnings ratio = $20 / $5 = 4
Note that the stock market is valuing SM’s competitor’s shares at a higher multiple of earnings than it is valuing SM’s shares. This disparity in PE ratios is usually related to differences in how the financial markets view the quality of earnings, past profitability, expected future earnings growth, or a combination of two or more of those factors.
Besides noting the PE ratio, some financial analysts also report a company’s PEG ratio (price–earnings growth ratio). Although the PEG ratio and traditional PE ratio have similarities, they conceptually have one fundamental difference. Specifically, the PEG ratio estimates what the future quarterly earnings will be besides using the previous three trailing estimates.
Financial statements provide important information about the condition of a firm. By using numbers in financial statements, we can get key information that allows us to summarize an organization’s liquidity, activity, financial leverage, and profitability. These ratios also allow a firm to examine its operations and ratios in comparison with publicly traded firms in the same industry. But when appropriate information is available, the market value of the firm should be used as a supplement to these accounting-based ratios. Market value is the true street value for a business (i.e., what someone would pay for a business today). Such a value is based on investor perceptions and the quality of available information about the company.