launched its virtual business without warehouses. When Barnes
and Nobel began online sales, Amazon lost market share.
Amazon acquired warehousing to compete with B&Ns
lower prices, but analysts reported two negatives: higher
fixed costs and unused capacity, leading to zero profitability.
Last week, we looked at EPSearnings per shareas
a measure of a firms profitability. We noted that one
needed to know how many shares were outstanding or issued.
But the future is what we try to predict, so heres the
story with Amazon: in 1998, Amazon had 159 million shares
outstanding, with a further 38 million owned by employees.
They had another 13 million share issue in the cards.
On top of that, Amazon, had issued debt instruments that could
be converted in the future into shares that could add another
eight million shares.
Amazon had also projected that its business strategy involved
mergers and acquisitions (M&As), which may require capital
injections and another share issue in the future.
Do you see the problem of todays evaluations for an
asset, such as a growth stock, from which the pay-off is not
expected until sometime in the future?
The P/E ratio or the earnings multiplier is another measure
that is used to access the attractiveness of a stock.
The price to earnings ratio indicates how much the market
is willing to pay for a share of equity in the firm.
It is calculated by dividing the current price per share,
by the earnings over the latest 12-month period, or the market
value per share divided by EPS.
Eg: If a company has one million shares outstanding and earned
$10 million last year, its EPS is 10-1 or $10. If the shares
sell at $50 per share, the P/E ratio is 50-10 or five.
This means investors will pay $5 for every $1 that was earned
last year. The assumption investors make is that future worth
will be a multiple of future earnings.
There are two major drawbacks to P/E: it uses the accounting
profits as declared earnings. Accounting profits may not be
best measure of the value creation in the firm.
Secondly, there is a debate about whether the industry multiplier
is the better multiplier. Many corrections are based on growth
projections, and the WACC-weighted average cost of capital.
The DCF (discounted cash flow) valuation may be a superior
indicator, because it incorporates what is known as time value
of money and risk premium.
Risk premium is an investors expectation of extra compensation
for taking the risk, in the event that the future cash flows
The time value of money is the compensation investors demand
for waiting until a future date, to realise gain.
In fact, the DFC is really the amount an investor is willing
to pay now for cash flows in the future. It converts tomorrows
cash into a value for today.
It is calculated using three estimates: the cash you put out
today, the cash you expect to receive and the time involved.
Eg: If you expect to realise $40,000 of income at the end
of the time frame of 12 years, and the inflation rate is six
per cent, the value of $40,000 discounted is really $20,000.
The present value of money is a better indicator than reported
earnings, because of the divide between the value of the firms
cash and physical assets and the firms total value,
as determined by the stock market.
In fact, the 1929 stock market crash was a reported
earnings fiasco, which launched the DFC method.