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

The Daily Telegraph - Business - - Business - RICHARD EVANS Read Questor’s rules of in­vest­ment be­fore you fol­low our tips: tele­graph.co.uk/go/ questor­rules; twit­ter.com/DTquestor

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.

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