Investors look for various indicators to assess the viability of investing in a particular company or industry. The following discussion looks at some of these key performance indicators, their applicability, and a case study of two UK firms from different industries. The case studies help demonstrate some of the methods applied by investors in their decision-making process.
Differences between market value and balance sheet value for a company
Market value can be defined as the total market capitalization of a company while taking into account the market value of its debt. Market capitalization could be attained by multiplying the current stock price of a company in a publicly-traded stock exchange, by the number of outstanding shares in the market. The market value of a company could help denote certain analytical factors such as the profitability of a company, its cost-effectiveness, and general performance in the market. In essence, the market value of a company conveys the attitude of investors towards the given company. Therefore, a rising market value shows that investors have a positive future outlook for the given company and vice versa.
Conversely, the book value of a company is the net value of its assets as shown in the books of accounting. “The book value of a common share is equal to the net worth (paid-up capital plus reserves and surplus) divided by the number of common shares outstanding. In the balance sheet, assets are generally shown at original cost minus depreciation” (Lough 2010, 9). For several reasons, the real worth of an asset might change over time but the accounting measurement of assets does not show the real worth or the current market value. There is, therefore, a considerable difference between the accounting (book) concept of the value and the market value of assets, and therefore companies. Through the accounting concept, assets could be said to be written down to their cost, rather than value, while the true concept of value manifests itself in the market system, where “value” is what something is currently worth.
The market value of assets or securities is the going price at which they can fetch in the market. A company will have two market values, that is; a liquidating value and a going concern value. The liquidating value is the money that a company would get after disposing of its assets after ceasing operations. As the firm will stop business operations when liquidated, its organization will be valueless; hence the liquidation concept does not consider the value of intangibles such as goodwill, brand value, and human resources (Lough 2010, 14).
Alternatively, the going concern value is the price at which a business could be sold, assuming that it will continue with its business practices into the foreseeable future. The price depends on the soundness of the business, presently and in the future. As such, the going concern value is usually higher than the liquidation value since the former incorporates the value of intangible assets. Therefore, it can be said that the liquidation value of an enterprise is its book value, while the market value of the same company could be its going concern value. The book value of assets is dependent on the historical cost that may not be pertinent currently and in times to come. Generally, the market value of shares should depend on the firm’s returns, that is, cash inflows and their timing and risk. Profitability may also cause disparities between the market value and the book value per share, where the market value per share of the vibrant companies tends to be more than the book value per share. Similarly, the book value per share may be higher than its market value when a firm is experiencing losses since the written-down value of assets remains the same in both cases.
Investor and profitability ratios
Profitability ratios are used to determine the operating efficiency of a firm, as well as growth in earnings. Besides the management of the company, creditors and owners are also interested in the profitability of the firm. Creditors, such as corporate bondholders, would want to get interest payments regularly and return of principal at maturity. Owners and potential investors of the company will want to get a reasonable return from their investments, which is only feasible when the business makes enough profits that cover financial obligations and fund company growth. Two types of profitability ratios are usually considered; profitability in relation to sales and profitability in relation to investment. Profitability in relation to sales covers ratios such as the gross profit margin and the net profit margin, which both interpret how efficient the company is in the derivation of its revenues (Nikolai, Bazley & Jones 2009, 25).
Measuring the profitability of a firm in relation to investment could be calculated via the return on investment (ROI) concept. The phrase investment refers to total assets, capital contributed, or the owner’s shareholding. The return on assets (ROA), also known as the profit-to-assets ratio, is calculated by dividing a company’s net profits by its total assets. This ratio is conceptually unsound as it excludes interest charges from the net profit figure. The total assets have been financed from the pool of funds supplied by creditors and owners. Therefore, to measure how well the “pool” of funds has been used, the return can be compared with the cost of using such funds (London Stock Exchange 2010, np)
Consequently, to arrive at the real earnings, the interest charges should be included in the net profit after taxes. ROA is a useful measure of the profitability of ALL financial resources invested in the firm’s assets. It evaluates the use of total funds without any regard to the sources of such funds. This ratio is particularly useful to evaluate the performance of divisions in a multi-divisional firm. Generally, these divisions have the responsibility of using and controlling assets without any responsibility towards raising and utilizing funds ((Gove et al. 1961, 63).
The return on capital employed (ROCE) shows how efficiently the firm has utilized funds committed by its shareholders and creditors. The higher the ratio, the more efficient the firm is in using the funds entrusted to it. “When the ratio is evaluated to ratios of like companies and the industry average, the comparison will reveal the operating efficiency of the firm. Return on shareholders’ equity is calculated after having deducted taxes and preference share dividends from the company’s net earnings” (Guthmann & Dougall 2009, 50). The earning of a satisfactory return is the most desirable objective of each business in the UK, where the ratio of net profit to owner’s equity reflects the extent to which the objective has been achieved. The returns on owners’ equity while compared with similar companies and the industry average could reveal the relative performance and relative strength of the company in attracting future investments.
The profitableness of common shareholders’ investments can be measured in many other ways, where one of the most widely used measures is the earnings per share (EPS) ratio. “The EPS is a firm’s accounting earnings against the number of common outstanding shares” (Guthmann & Dougall 2009, 86). The earnings per share calculations made over consecutive years indicate whether or not the company’s earning power on a per-share basis has changed over that period. The earnings per share of the company should be compared with the industry average and similar data of other firms.
Where a company employs financial leverage, the earnings per share figure increases without a rise in the owners’ equity if the use of debt yield returns higher than the cost of debt. Similarly, EPS may also increase when preference share capital is used to acquire capital. The leverage impact is more pronounced in the case of debt because the cost of debt is usually lower than the cost of preference share capital and the interest paid on debt is tax-deductible. The companies with high levels of earnings before interest and taxes (EBIT) can make profitable use of the high degree of leverage to increase return on shareholders’ equity (Connolly 2006, 79).
EPS is one of the most widely used measures of a company’s financial performance, while its major shortcoming is that it ignores the solvency risk factor. The market usually adjusts a company’s share price to reflect expected EPS levels, whereby the share price would rise when the company announces higher than expected results or fall when earnings are below expectations. If the objective of the company is to maximize EPS, then the plans for the highest level of debt will be chosen. In most cases, the EPS criterion will favor the use of leverage. If EBIT is constant, and the company’s after-tax borrowing cost is less than its return or earnings-price ratio, then EPS will always increase with an increase in leverage (Rogers, & Makonnen 2002, 47).
Case study 1: BP PLC
BP is a public limited company trading under the name BP PLC in the London stock exchange, where it is also a constituent of the FTSE 100 index. The company is in the integrated oil and gas industry and ranks as among the biggest companies in the world as measured in terms of revenues and assets. The company’s revenues are sourced from a diversified variety of activities in the oil and gas industry, including “exploration, production, and marketing of oil and gas products all over the world” (BP Global 2011, np). The company’s fortunes have been mixed, given its recent track record on environmental issues.
BP currently had a market capitalization of £94 billion, as of Dec 31 2009 where sales and other operating revenues were recorded at £153 billion (londonstockexchange.com) for the year ended Jan 2010. Companies in the energies sector have been affected by the fluctuation of crude oil prices in the world, reaching a peak price of around $145 per barrel in June 2008 and below $40 per barrel in December of the same year. The EPS ratio ranged from 109 cents in 2007, 113 cents in 2008, and 88 cents in 2009, representing EPS growth rates of -1.00%, 4%, and -21% respectively for the 3 years. This could be explained by the relatively slow growth in revenues for the three years in question. There is a little disparity between basic EPS and diluted EPS, signifying to investors that their investments are relatively safe from debt holders (Yahoo finance 2011, np).
The return on capital employed (ROCE) decreased significantly in 2009, at 17.89% from 26.89% in 2008. This could be due to the relatively lower oil prices in 2009 compared to the high 2008 prices. Both the EPS and ROCE are expected to drop further in 2010 in the wake of the Gulf of Mexico disaster which cost BP billions of dollars in clean-up expenses, compensations, US government fines, and significantly high deposit into the US escrow account. As a result, the market capitalization of the company was almost halved in the period, where share prices reached 304.6 cents on June 25, 2010, from as high as 642.5 cents only a month earlier.
Case study 2: Diageo Plc
Diageo plc, another constituent of the FTSE 100, is a multinational alcoholic beverages company with its global headquarters situated in London, UK. The company’s primary listing is in the London stock exchange, where it trades under the beverages sector. The company sources its revenues from a variety of brands in different classes of alcoholic beverages, selling its products in countries worldwide with an estimated market capitalization of US$ 49 billion. Like most other global companies, the company’s revenues were affected by the 2007/08 global recession, but the company has since bounced back to revenue growth due to increasing demand for its products.
Diageo has experienced growth in revenues, while maintaining an operating margin of 19.86%, 19.89%, and 21% for years 2010, 2009, and 2008 respectively (londonstockexchange.com). This has meant that profits have also improved for the company, with EPS figures rising from 58.26 pence in 2008 to 64.5p and 66.3p in 2009 and 2010 respectively. As a result, the company’s share prices have been rising gradually, from 943 cents on Jan 21, 2008, to 1,235 cents on Jan 17, 2011. The rising share prices also reflect the rising dividends paid out per share by the company, from 34.35p in 2008, 36.10p in 2009, and 38.10p in 2010. The rising dividend payout ratio could signify that the company expects continual growth in earnings, which may further make the stock attractive (Google finance 2011, np).
The return on capital employed has been declining in recent years for the company. Although the company is on a slow revenue growth rate, the company is relatively safe for investors to purchase the stock. Unlike BP which is in the oil and gas sector, Diageo enjoys the price stability of its products given the fact that it can set its own prices. The net effect of setting its own prices is that the company can stabilize revenues in light of changes in the economy. The declining ROCE, given the rising revenues, could be explained by the acquisition of more assets by the company in accordance with its growth strategy.
The usefulness of investor and profitability ratios
In the UK, the FTSE Group maintains an index that measures the performance of the stock markets in Britain. The various market indices illustrate the market performance of the component companies, based on their market capitalization. Investors, in turn, use such information to gauge the overall performance of the market, whereby a strong rise in the market index could be explained by strong investor confidence or a growing economy, while a declining index indicates loss in confidence or a gloomy outlook on a macroeconomic level (McLaney 2009, 105).
The market value of an individual firm could be affected by the news and speculation regarding its earnings potential, as well as information concerning its current profitability. As mentioned, one of the users of market value information of UK listed companies in the FTSE Group, which uses such information when deriving market indices. A market index is a collection of securities, whose prices are averaged to reflect the overall investment performance of a particular market for financial assets, say the UK securities market. Investors in turn use this information to gauge the general performance in the market, and the economy (Office for national statistics 2011, np).
With the help of ratios, investors can determine the ability of a firm to meet its obligations, the solvency risk that the company is exposed to, the efficiency with which a company is utilizing its various assets in generating revenues, and the overall operating efficiency, performance and growth prospects of a firm or industry. When plotted on a graph, Log EPS and Log similarly share price move thereby indicating a general trend of the two parameters, although the two are not parallel. The average price per share tends to be inversely related to market capitalization. Furthermore, the smaller is the market capitalization of a traded stock, the greater is the price impact of the trade since commissions stated as a percentage of the pound value of a trade increase as market capitalization declines. Investors can use this information so as to manage transaction costs, or predict price changes in share prices in response to EPS changes and therefore act accordingly.
BP Global, 2011. ‘Investors.’ BP Global. Web.
Connolly, B., 2006. International business finance. Florence, KY: Taylor & Francis.
Google finance, 2011. ‘Diageo plc (ADR) (Public, NYSE:DEO).’ Google finance. Web.
Gove, P. et al., 1961. Finance. Webster’s Third New International Dictionary of the English Language Unabridged. Springfield, Massachusetts: G. & C. Merriam Company.
Guthmann, G. & Dougall, H., 2009. Corporate financial policy, Edition 3. Portage, OH: Prentice-Hall.
London Stock Exchange, 2010. ‘Company profiles.’ London Stock Exchange. Web.
Lough, W., 2010. Business Finance a Practical Study of Financial Management in Private Business Concerns. Santa Cruz, CA: Read Books Design.
McLaney, E., 2009. Business Finance. New York: Financial Times/ Prentice Hall.
Nikolai, L., Bazley, J. & Jones, P., 2009. Intermediate Accounting. New York: Cengage Learning.
Office for national statistics. 2011. ‘Capital stocks tables for publication.’ Office for national statistics. Web.
Rogers, S. & Makonnen, R., 2002. The entrepreneur’s guide to finance and business: wealth creation techniques for growing a business. New York, NY: McGraw-Hill Professional.
Yahoo finance, 2011. ‘BP p.l.c. Common Stock (NYSE: BP).’ Yahoo finance. Web.