It’s time to look at obscure terms such as enterprise value – and why they matter
After last week’s look at turnover and profits we cover operating margins and free cash flow yields – because they help us to be better investors
LAST week we attempted to explain some of the common terms in use when firms report results or when analysts or investors put businesses under the microscope. Today we move on to some slightly more obscure ones.
We covered market value last week but a related expression you sometimes see is enterprise value. This represents what a buyer would have to pay to take over a business in its entirety: all the shares (collectively worth the market value) plus the cost of assuming any debts plus the cost of other obligations such as any pension deficit or leases. Enterprise value is, accordingly, often used in takeovers and, as Warren Buffett says, you should see buying a single share as if you were buying the company. Operating profits, found in the income statement
section of a firm’s annual report, strip out the costs of debt interest (or interest received on cash). They isolate the profits made by the actual business – the factory, chain of shops or whatever it is – and disregard the funding arrangements of the entity that owns it.
Profit margin is simply the ratio of profits to turnover. The profits used can be pre-tax, after-tax or operating. If the bare term “profit margin” is used it will probably mean the aftertax margin, but the operating margin gives more insight into the health of the actual business.
Two other measures that strip out interest are Ebit – earnings before interest and taxes – and Ebitda, which additionally excludes depreciation and amortisation. Depreciation is the loss of value of a tangible asset in a year; amortisation is the same but for an intangible asset.
Ebit will sometimes, but not always, equal operating profits. They can differ, for example, when some income is regarded as “non-operational” but still included in the definition of Ebit.
We mentioned adjusted profits in passing last week. Companies will sometimes exclude certain types of expense to give a more “like-forlike”
idea of performance (or, less appealingly, to flatter their figures). For example, restructuring expenses could be omitted if they occur exceptionally in just that one year. Also called “underlying” profits. Treat with caution: it can amount to firms “marking their own homework”.
Earnings per share, or EPS, are after-tax profits divided by the number of shares in issue. You will often see profit for the period in the income statement. It is the same as the after-tax profit except that it also accounts for other deductions such as dividends on preference shares.
We covered the price-to-earnings, or p/e, ratio last week. A related measure is the earnings yield, which is the same ratio inverted: after-tax profits divided by market value. Another yield is the free cash
flow yield. We went into some of the differences between a company’s profits and its cash flow last week. The cash flow yield is the free cash generated by the business divided by the market value. “Free” cash flow normally means what is left after every expense, such as tax, dividends, interest and any investment that has to be made to maintain the business’s capacity to operate, has been met. Some firms leave items out of their definition, so care is needed. If a company has a cash conversion ratio (covered last week) of 100pc, the earnings yield and the free cash flow yield will be the same.
The Peg ratio represents an attempt to put the more familiar p/e ratio in context by relating it to the company’s growth. A high p/e often reflects expectations of above-average growth and by dividing the p/e by the annual percentage growth rate we can judge whether one stock is more highly valued than another even if one is growing more quickly. The rule of thumb of the Peg ratio’s inventor, the late Jim Slater, a former Telegraph columnist, was that a Peg of less than 1 represented good value. This applied, of course, irrespective of how fast the company was growing.
Our key facts are for the same stock covered last week, Games Workshop.