Let’s go up to the top end of company valuations, the value the stock market puts on the shares of a listed public company. This can be very volatile. If a number of people are selling blocks of shares in the same company, its share price may well go down. If lots of people want to buy shares the share price will go up. This changes the value of the company on a day-by-day, or actually minute-by-minute basis. That value is often called the capitalisation of the company and is a simple calculation – the price of a share today multiplied by the number of shares. You can read that value in the financial pages of the newspapers.
Don’t forget that the value people put on public companies listed on the stock exchange is just the same as an investor in small and medium sized enterprises. It reflects investors’ opinion of the ability of the company to grow profits allowing them to pay dividends and increase those dividend payments in the future.
Another wee bit of revision from last week’s blog – remember that the best indicator of the value of your house was to look at what people paid for similar properties recently. So the best indication of the opinion of the professionals working in the stock market as to the value of a company is to look at what recent investors paid for the share. You get that too from the business pages.
So how does an investor use this information? Well, they know yesterdays share price and they can find out what profits, often called earnings, the company made in the last year from the company’s web site. Divide the share price by the earnings per share figure and you get a key ratio known as the Price/Earnings ratio, the P/E. Knowing how this calculation is made is useful; but investors don’t have to do it for themselves because the journalists on the financial pages have done it for them. You can read the P/E on a daily basis in the papers or on numerous sites online.
Tip from Shaf – Learn the basics
If you want to learn more about reading the financial pages or interpreting a company’s annual report there’s an excellent book on the subject – Smart Finance by Ken Langdon and Alan Bonham published by Capstone.
So how does knowing the P/E help the investor to evaluate if a company has little or large prospects for growing its business and its profits? If the market believes that the company has steady growth prospects the P/E will be low, if the market expects the company to kick up a storm in the future the P/E will be high. So, a utility company could have a P/E as low as, say, 5 while the market might believe that a high-flying software company might look such an attractive growth prospect that shareholders will still buy the shares when the P/E is as high as, say, 40.
Now in the Dragons’ Den we can get the information on one side of the P/E ratio by asking the person looking for investment what profits, if any, the company made last year. But we don’t get the other side of the equation because nobody has bought shares in the company recently – there is no share price. So, that’s what we are trying to assess when people are presenting to us, what is the company’s real potential for growing profits and when is that growth likely to take place. This allows us to have a stab, if you like, at calculating a fair price for the share. After all, we are at the start of the chain of company growth that eventually produces the public limited companies of the future.
The next blog will look at what you can do to prepare yourself to impress a potential investor and give yourself the best chance of getting the money.
Valuing a company is much easier if you can detect what experts think is its likely future performance
