It’s simple, the last reported sale of a single share of a publicly traded company’s stock can be used — and is frequently used — to establish the market value of the entire company. The Earnings Per Share is simply the price of the sale, multiplied by the number of shares outstanding: that is the company’s valuation.  More succinctly, EPS x price, x shares outstanding = public market valuation.

The buyer of the whole company could more simply think in terms of the number of years of after-tax earnings that would be necessary to equal or justify the amount being paid for the company. Of course, it is not just the after-tax earnings of the last 12 months which would be used, but rather the anticipated period for the buyer to be in position to own the asset at a zero-cost basis. Therefore, the earnings estimate is critical, and if possible, the buyer will be able to hedge the purchase amount, structure and/or scheduling of payment. Purchases of companies can, but do not have to be, 100% cash, paid at closing, with or without investor protections.

If equity market indices are trading at a Price/Earnings ratio of 18, that means that it will take 18 years at that level of earnings for the cumulative earnings to equal the cost of the index. Investors buying a stock which has a current P/E of 50 are not assuming that it will take 50 years to recapture their cost, but that the company’s earnings will increase dramatically. The actual valuation will also reflect the investor’s assessment of the type of company, the products or services produced, the cost of production, the intellectual property owned, the effectiveness of competitors, the characteristics of major customers, the physical property held and its location, long- and short-term debt and terms, outstanding options held by insiders and outsiders, their terms and exercise prices, unconsolidated corporate holdings, typically international, and finally the integrity and efficiency of company management.

There are also large and profitable companies selling on public equity exchanges for less than half of the P/E of the index, and some for only 5 times the per- share earnings of the last 12 months. In these cases, investors are implicitly anticipating that the EPS will decline significantly in the coming years — if one accepts the P/E as an accurate macro view of investor sentiment

It is probably true that stock prices commonly reflect to a greater extent the extreme predictions, both good and bad, rather than those anticipating a more moderate change in EPS. Therefore, based on competent research, the sale of some high P/E stocks balanced by the purchase of some low P/E stocks is an investment portfolio manager’s preferred portfolio structure.

What seems clear to me is that betting against the extremes is better than unquestionably accepting the extreme views.

Of course, in the end it’s all a matter of the investor’s experience and judgment, which should, and often does, outweigh the abstract numbers.

 

 

Arthur Lipper, Chairman                          arthurlipper@gmail.com
British Far East Holdings Ltd.