Sunday 9th April, 2006

 

Predicting the future of shares

 
 
 
 
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Amazon.com launched its virtual business without warehouses. When Barnes and Nobel began online sales, Amazon lost market share.

Amazon acquired warehousing to compete with B&N’s lower prices, but analysts reported two negatives: higher fixed costs and unused capacity, leading to zero profitability.

Last week, we looked at EPS—earnings per share—as a measure of a firm’s 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 here’s 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 today’s 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 investor’s expectation of extra compensation for taking the risk, in the event that the future cash flows stagnate.

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 tomorrow’s 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 firm’s cash and physical assets and the firm’s 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.

©2005-2006 Trinidad Publishing Company Limited

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