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Wednesday, 31 October 2012

Determining the value of a company

The first rule is...don't lose money.

Without profits a company cannot survive. Even the most dazzling accounting tricks can only keep a profitless company afloat for so long, as Enron and CS Holdings have proved, which is why earnings per share is such an important number.

Simply put, earnings per share are the amount of bottom-line taxed profit a company makes, divided by the number of shares the company has in issue.

In other words if a company makes a net profit of R1 000 000 in a year and has 10 000 shares in issue, the earnings per share number would be R1 000 000 divided by 10 000 which is R100 per share.

However, as always, there are complications and there is more than one version of the number.

In South Africa, most companies report at least two versions of earnings per share.

Traditional earnings per share, net profit divided by shares in issue, is reported but is overshadowed by its cousin headline earnings per share, found by taking headline earnings and divided by shares in issue.

Headline earnings are those earnings the company believes to be sustainable in the long term and is found by taking net profit and leaving out income flows or costs that will not happen again, or as companies put, stripping out the non-recurring items.

For example, Massmart, the company that owns the Makro chain of stores, was hit by fire. The company stripped out the cost incurred by the loss of stock and buildings in 2004 and then in the 2005 financial after the insurance claim was paid out after the fires was not included its headline earnings figure for that year. One wag suggested that fires are so regular at Massmart that they should not be seen as non-recurring.

There are also two other factors that often affect the eps figure.

The first of these is the number of shares in issue. This can vary from year to year as the company issues more shares in acquisitions or in delivering on share options given to executives.

Often share issues take place late in the financial year. In this case, the number of shares in issue for the eps calculation is "weighted" to reflect that the shares were not in issue all year.

As a conservative measure, some companies give a fully diluted earnings per share figure, in which no such weighting is made.

The other factor that affects South African companies is black economic empowerment.

Because BEE deals are often based on share issues on specially favourable terms, the fact has to be recognised. The "discount" at which shares are issued has to be expensed.

Other factors that can raise and lower published earnings figures are the writing down of goodwill, and the impairment of assets. The headline earnings figure aims to show the sustainable earnings in the given year and normally excludes such items.

It is the headline earnings figure that is used to calculate the price earnings multiple on the share page.

However, like all numbers, eps is meaningless in isolation and any company's earnings figure should be viewed in relation to comparable numbers both from previous years and the eps numbers from companies in its peer group.

Earnings as such have been criticised for forcing companies to expense items such as research and development in the year in which they occur - when the benefits accrue over many years. That is why most analysts do their own calculations, taking out or including items that they feel best reflect the picture.

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