How to value companies

The golden rule of investment is this: don't lose money.

There are lots of ways to lose money. But probably the most common mistake investors make is to pay too much for a share.

This is usually because they let their emotions get the better of them. They fall in love with a company and its promises of stellar profits for years to come. Rather than waiting to buy at the right price, they feel that they must buy in now.

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Sometimes you can get lucky and make lots of money doing this. But more often than not, the hopes for big profits turn out to be just that hopes.

When the profits don't materialise, disappointed shareholders sell out and the share price plunges. The gung-ho buyer who was convinced that they couldn't go wrong, now finds themselves staring at a big loss.

How do you work out what to pay for a share?

The big question is what should you pay for a share? How much is too much? What price represents a bargain?

There are no right or easy answers to these questions. Some books on investment will tell you that the value of a company and therefore its share price is quite straightforward.

It's the amount of surplus cash that it can generate between now and the end of its life, expressed in today's money.

Sounds simple doesn't it? You just need to forecast what a company's cash flow will be for every year until the end of time. Then you choose an interest rate that will give you a realistic idea of what these future cash flows are worth today.

This might work reasonably well if you buy a bond, where you get a series of known interest payments over ten years and then get your money back.

But it's not very helpful in practice when you are buying shares. That's because human beings are terrible at predicting the future.

Even professional investors will struggle to accurately predict how much money a company will make in one or two year's time, let alone in 50 or 100.

Valuing a company is an art, not a science. You just have to accept that you cannot predict the future, and that you have to find some form of compromise.

Thankfully, there are some simpler methods of valuing shares that can stop you from paying too much.

Shares as savings accounts

When you open a savings account, the bank or building society pays you a rate of interest. These days you might get 3% on your hard-earned cash if you are lucky. There's no reason why you can't look at shares in the same way.

How? You just look at how much money a company makes for its investors, then divide this number by what you have to pay for it.

In other words, you take the company's profits (also known as earnings), dividends, or cash flow per share. You then divide by the current share price to get a comparison with a savings account.

For example, Bob's Beers has a share price of 100p. It has earnings per share (EPS) of 10p, pays dividends of 5p per share (DPS) and has cash flows of 8p per share. This gives the shares an earnings yield of 10% (10/100), a dividend yield of 5% (5/100) and a cash flow yield of 8% (8/100).

Now remember, shares are not like savings accounts. Unless you have more than £85,000 in your savings account, you are guaranteed to get your money back even if the bank goes bust.

With shares, you are the last in line to get paid. If the company goes bust you can lose everything. This is why you should insist on getting paid extra to take on this risk. You should buy shares that will give you a better return than cash in the bank.

What measure of return should you use? It depends. Some people argue that company directors can use various accounting tricks to make profits what they want them to be. Dividends and cash flows on the other hand are real. Some would say that only dividends represent a proper tangible return from owning shares.

A real life example - Vodafone

But those are topics for another time. Let's take a look at an example of how this works in practice.

During the peak of internet and telecom mania of 1999 and 2000, mobile phone giant Vodafone was a stock market darling. Its shares reached 456p in March 2000.

At the time, it had earnings per share of 4.71p and was paying a dividend per share of 1.33p. Its earnings yield was a miniscule 1% and dividend yield 0.3%.

Yet very few City analysts said that its shares were horrendously overvalued. Two years later, the shares had plummeted to 92p as investors finally woke up and realised that profits were not heading for the stratosphere.

At that level, the shares had earnings and dividend yields of 5.6% and 1.6% respectively. This was still not really cheap but more reasonable for a company that was still growing its profits.

Fast forward to 2012, and Vodafone's profits and dividends are a lot higher. WithEPS of 14.9p, a person buying at 92p has an earnings yield on their purchase price of 16.2%. WithDPS of 9.52p, the dividend yield on the purchase price is 10.3% much better than the returns you could have received on any savings account.

Contrast that with anyone buying at the high price in 2000. The earnings yield on cost is still a tiny 3.3% with the dividend yield just 2%. This is stark proof that Vodafone was not capable of growing its profits fast enough to justify its ridiculously high share price back then.

But what about the value of Vodafone shares now? At 178p, they have an earnings yield of 8.4% and dividend yield of 5.3%. If they can still grow profits and dividends modestly that price looks about right.

There's no perfect valuation method

Every method of valuing a share has its pros and cons. We have shown you some very simple methods that hopefully go a long way to keeping you out of trouble.

It's also important to remember that valuation is just one part of the investment process. It's just as vital as we discussed last time (How to buy great companies) that you keep asking whether you own, or are looking to buy, the shares of a good or great business.