Read the Numbers, Understand the Business
Chapter 7 of 8 · 10 min read
Connect business quality with the price paid
Even a strong company can be a poor investment if its shares are purchased at an unrealistic price. Business quality and valuation are different questions, and both matter.
The idea of durable earning power
A company that maintains useful margins, generates cash, earns attractive returns on capital and avoids excessive debt may have greater capacity to compound value over time. But future earnings can still decline because of competition, management decisions, regulation or technological change.
Price-to-earnings ratio
P/E ratio = Share price ÷ Earnings per share
If a share costs $30 and annual earnings per share are $2, the P/E ratio is 15. This is a comparison of market price with current accounting earnings. It is not a complete measure of value. Earnings may be cyclical, temporarily inflated, depressed or influenced by accounting choices.
- P/E = $30 ÷ $2 = 15
- FCF yield = $5m ÷ $100m = 5%
Free-cash-flow yield
A complementary approach compares available annual free cash flow with the company’s market value. If a business has an equity market value of $100 million and an appropriately measured $5 million in annual free cash flow attributable to equity holders, its illustrative equity free-cash-flow yield is 5%.
Be careful: the common operating-cash-flow-minus-capex calculation is not always equivalent to cash flow available to shareholders. Debt financing, lease obligations, working capital and other adjustments matter.
Why assumptions dominate valuation
Any projection of future cash depends on growth, margins, reinvestment, financing, risk and the discount rate. Small changes in assumptions can make a large difference to estimated value, especially when most expected cash arrives many years in the future.
A useful valuation process therefore uses scenarios:
- Conservative: Slower sales growth, weaker margins, higher reinvestment.
- Base case: Plausible performance informed by history and current conditions.
- Optimistic: Strong execution and a sustained economic advantage.
Look at the range of estimated outcomes rather than treating one precise number as certain.
Use normal earnings, not this year’s
A P/E ratio is only as meaningful as the earnings beneath it. If this year’s profit is unusually high, because of a peak in the cycle or a one-off gain, the P/E will look low and the shares cheap. If profit is temporarily depressed, the P/E will look high even if the shares are reasonably priced.
A common adjustment is to estimate normal earnings: what the business might earn in an ordinary year. One approach applies the company’s average margin over a full cycle to its current revenue, then deducts interest and tax at normal rates. The result is an estimate, not a fact, but a P/E based on it is usually a better guide than one based on a single exceptional year. For cyclical companies, a low P/E at the top of the cycle is one of the most common traps.
What a P/E implies
Turning the P/E upside down gives the earnings yield: earnings per share divided by the share price. A P/E of 15 corresponds to an earnings yield of about 6.7%. It shows how much profit each dollar invested currently represents.
That yield can be compared with what safer investments offer, but with care. A company’s earnings may grow, which a fixed-interest investment’s payments do not, so a lower earnings yield can be justified for a business with good prospects. It may also shrink, which is why a higher yield is needed for a business facing decline. The earnings yield is a starting point for asking how much growth or risk the price already reflects.
Enterprise value: price the whole business
The P/E compares price with profit after interest, so two companies with the same P/E can carry very different debts. Enterprise value adds net debt to the market value of the shares, giving the price of the whole business, debt included. It can then be compared with operating profit before interest, often called EBIT.
This is an illustration. A company with shares worth $100 million and net debt of $20 million has an enterprise value of $120 million. If its EBIT is $8 million, its EV/EBIT is 15. Another company with the same share value but no debt, earning the same EBIT, would have an EV/EBIT of 12.5. The second is cheaper for the same operating earnings, a difference the P/E alone might hide.
A simple discounted cash flow
The value of a business is, in principle, the cash it will generate in future, discounted back to today to reflect time and risk. A discounted cash flow (DCF) estimate makes those assumptions explicit.
This is an illustration with stated assumptions. A business currently generates $5 million of free cash flow to equity. Assume it grows 4% a year for five years, then 2.5% a year indefinitely, and that investors require a 9% annual return for its risk.
- The free cash flow in years 1 to 5, discounted at 9%, is worth about $21.8 million today.
- By year 5, annual free cash flow reaches about $6.1 million. Valuing the cash flows after that as a growing perpetuity gives about $95.9 million at year 5, worth about $62.3 million today.
- The estimated value is about $84 million.
- Next five years, discounted
- All later years, discounted
Notice how much of the value sits beyond year 5: nearly three-quarters. That is typical, and it is why the assumptions about long-term growth and the required return dominate the result.
How sensitive the answer is
Changing the two most uncertain assumptions shows how wide the range of reasonable values is. Keeping the first five years the same:
| Required return | Long-term growth 2% | 2.5% | 3% |
|---|---|---|---|
| 8% | $93m | $100m | $108m |
| 9% | $79m | $84m | $90m |
| 10% | $69m | $73m | $77m |
A one percentage point change in the required return moves the estimate by more than $10 million, and the full table spans from about $69 million to $108 million. That range, not any single number, is the honest output of the analysis.
Ask what the price already assumes
Instead of estimating value and comparing it with the price, the calculation can be run backwards: what growth would justify the current price? If the shares are worth $100 million in total and the business generates $5 million of free cash flow, treating it as a perpetuity at a 9% required return implies growth of about 3.8% a year, forever.
That turns the question into one about the business. Is it reasonable to expect this company to grow its free cash flow by nearly 4% a year indefinitely, given its industry, returns and history? If the answer is yes, the price may be fair. If that seems demanding, the price may already reflect an optimistic future. Reverse calculations like this are often more useful than a single valuation, because they focus attention on the assumption that matters most.
Leave a margin of safety
Because every valuation rests on uncertain assumptions, many investors look for a margin of safety: a price comfortably below their estimate of value, so that the investment can still work out if some assumptions prove too optimistic. In the example, a price well below the base-case $84 million would provide some cushion; a price of $100 million provides none, unless the more optimistic assumptions are justified.
The margin needed depends on how confident the estimate can be. A steady business with a long record warrants a smaller margin than one whose future depends on a new product or a recovery that has not yet happened.
Dividend yield and its limits
The dividend yield is the annual dividend per share divided by the share price. A share priced at $30 that pays $1.20 a year in dividends has a yield of 4%. For investors who want income, it is an obvious measure to check.
A high yield is not automatically attractive. It can mean the share price has fallen because the market expects the dividend to be cut. Before relying on a yield, check the cover described in Chapter 4: whether the dividend is comfortably paid from free cash flow over several years, and whether the company’s debt and investment needs leave room to keep paying it. A modest yield that is well covered and growing can be worth more over time than a high yield that is at risk.
Price-to-book: useful in some industries
The price-to-book ratio compares the market value of the shares with the accounting equity on the balance sheet. It is most useful for businesses whose assets are mainly financial and recorded close to their market value, such as banks and insurers, and for asset-heavy businesses where the question is whether the shares trade above or below the value of what the company owns.
For many modern businesses, it is far less useful. A software company or a consulting firm may have little book equity, because its main assets, its people, customer relationships and know-how, do not appear on the balance sheet. A high price-to-book ratio for such a business says little about whether it is expensive. Buybacks can also shrink book equity, as Chapter 6 showed, which distorts the ratio further.
Compare like with like
Valuation measures are most informative when compared across similar companies and across a company’s own history. A P/E of 25 may be high for a slow-growing manufacturer and modest for a fast-growing business with high returns on capital. Comparing a company’s current measures with its own average over the past decade, and with close competitors, gives the number a context.
Check that the measures are calculated on the same basis. One source may use statutory earnings, another adjusted earnings; one may use the last reported year, another next year’s forecast. Mixing them makes companies look cheaper or more expensive than they are.
Common valuation mistakes
- Ask: Using a peak year's earnings for a cyclical business
- Ask: Treating one DCF result as the value, not a range
- Ask: Ignoring debt by comparing P/E ratios alone
- Ask: Assuming high growth will continue indefinitely
- Ask: Mixing adjusted and statutory earnings across companies
- Ask: Forgetting dilution from options and new shares
Each of these mistakes makes a valuation look more precise, or more favourable, than the evidence supports. The remedy in every case is the same as throughout this guide: be explicit about the assumptions, test them against the company’s history and its competitors, and treat the result as a range to be compared with the price rather than an answer.
Businesses that are not yet profitable
Earnings-based measures break down for companies that do not yet make a profit, such as young technology or biotechnology businesses. Their value depends almost entirely on what they may earn many years from now, so the uncertainty is far greater than for an established business.
Some investors use measures such as price-to-sales for such companies, but sales say nothing about whether the business will ever earn an adequate return. A more useful approach is to ask what the business would need to achieve, in revenue, margins and returns, for the current price to make sense, and to compare that with what similar mature businesses actually earn. Check how long the company’s cash will last at its current rate of spending, and how much further dilution is likely before it becomes self-funding. Treat any valuation of such a company as highly speculative, and size any decision accordingly.
Revisit the valuation as results arrive
A valuation is a snapshot of assumptions on a particular date. Each new set of results tests those assumptions. Keep the inputs you used, the growth rate, margins, reinvestment and required return, alongside your notes from earlier chapters, and update them when the evidence changes.
The useful question each time is not whether the share price has risen or fallen, but whether the business is tracking above, on or below the assumptions behind your estimate. A business that keeps beating conservative assumptions may be worth more than you thought; one that keeps falling short of base-case assumptions is telling you something, whatever its share price does in the meantime.
Valuation and the quality of the business
A higher price is not always a worse deal. A business with strong returns on capital, steady cash generation and a long runway for reinvestment can justify a higher P/E than one with poor returns, because each dollar it reinvests creates more value. The DCF arithmetic shows this directly: the same required return supports a higher value when long-term growth is higher, and Chapter 6 showed that sustainable growth depends on returns and reinvestment. Price and quality must therefore be judged together, never one without the other.
Key takeaway
A sound business analysis does not tell you what to pay until you also examine the uncertainty of its future cash flows.
Quick reference
- Is current profit representative of normal conditions?
- What price is being paid relative to earnings and cash generation?
- What growth and reinvestment assumptions are already priced in?
- What happens if the competitive advantage weakens?