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Conventional Valuation Yardsticks: Earnings, Book Value and Dividend Yield

February 28, 2012 | About:
Ale Schuvaks

Ale Schuvaks

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Earnings and book value are part of security analysis but must be used cautiously and as part of a more comprehensive valuation effort. Earnings per share have always been the valuation benchmark that is usually used by investors.

However, earnings constitute an imprecise measure and are sometimes subject to manipulation. Indeed, it is not intended to measure the cash generated or used by a business. Furthermore, they are almost impossible to forecast. Management at a company knows that investors focus on whether earnings have increased and it usually affixes them to create an upward trend. Other management groups may also manipulate results to turn a deteriorating situation into an improving one. They may also turn deteriorating results into better ones, turn losses into profits and small profits into large ones.

Anyway, with or without manipulation, the analysis of reported earnings can be misleading to investors in terms of the real profitability of a business. For instance, the Generally Accepted Accounting Principles (GAAP) may require actions that do not really reflect what is actually happens. This is the case of the amortization of goodwill. This charge can artificially depress reported earnings. In fact an analysis of cash flow would better capture the true economics of a business.

On the other hand, nonrecurring gains can greatly increase the levels of earnings but should be ignored by investors. Most importantly, regardless of the measure used by investors, either earnings or cash flow, they must remember that these figures are not final. On the contrary, they are a means to clearly understand what the company is doing and which its current situation is.

Now, what happens with book value? Book value is considered the historical accounting of shareholders´ equity. Sometimes it provides a correct measure of current value but other times it provides extremely different results. For example, current assets such as inventories and receivables are worth close to carrying value while there are other types of inventory that are subject to rapid obsolescence. Plant and equipment may become obsolete and therefore worth considerably less than carrying value.

There are factors that can significantly affect the value of assets in ways that historical cost accounting cannot capture. This is the case of inflation, technological change and regulation. For instance, real estate purchased several years ago and shown on the company´s records at historical cost may worth much more now. It may happen also that building a new oil refinery today turns out to be more expensive given the increasing environmental legislation.

Reported book value can also be affected by management actions. Write-offs of money-losing operations are somewhat arbitrary but they can still have a large impact on reported book value. Another factor that may affect book value is share issuance and repurchases. For example, in the 1980s there were many companies that performed recapitalizations, by means of which money was borrowed and dividends were distributed among shareholders. This led to a significant reduction in the companies´ book value, even below zero. Even the accounting method for mergers can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. However, two companies with identical tangible assets and liabilities can have very different reported book values. This is due to the accounting rules and management actions. This renders book value not terribly useful as a valuation yardstick. Just like in earnings, book value provides limited information to investors and shall be deemed one of the components of a complete analysis.

Now let´s turn to dividend yield. This measure is not frequently used. It has become a relic. It used to be applied to measure business prosperity. Indeed, stocks should not be bought based on the dividend yield. Sometimes companies report high dividend yields. Nonetheless, these levels are not due to an increase in dividends but to a drop in the price of shares. There are cases when management fears that the stock price will drop if the dividend payout ratio decreases. Therefore, it tries to maintain such payout ratio weakening the company even more. Investors feel attracted to the dividend that the company pays but they do not receive good value. They even become the victims of manipulation. The dividend they receive is not a return on invested capital. It is a return on capital that represents the liquidation of the underlying business.

To sum up, it can be noticed that business valuation is a complex process that provides inaccurate results. There are many businesses that are either complex or diverse and therefore, they are very difficult to value. Investors invest in these businesses because they get impatient. However, they have to bear in mind that they do not need to be permanently changing. On the other hand, they should be selective. Although there are businesses that cannot be assessed, there are many more that can.

An investor who acts according to what he knows have advantages over others.


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