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The Price to Earnings (PE) ratio seems to get all the attention but it’s the lesser-known little sibling, the Price to Earnings Growth (PEG) ratio that is gaining momentum. The PEG ratio moves the PE ratio to the next level by helping to determine whether a company is undervalued, overvalued, or fairly valued.

The PE ratio is typically calculated by dividing a company’s stock price by it’s earnings per share. High PE ratios indicate stronger growth stocks while lower PE ratios indicate lower growth stocks. In other words, an investor is willing to pay more for $1 of earnings if the company is expected to grow at a healthy rate. The bigger issue, however, is whether or not the company is overvalued. Enter the PEG ratio.

The PEG divides a PE ratio by the company’s earnings growth rate. A PEG greater than one indicates an overvalued company and a PEG less than one indicates an undervalued company. While far from perfect, the PEG ratio offers a reasonable answer to the question “Is this company overvalued.”

Mergers and acquisitions are showing signs of life in an otherwise week market. What drives a company to acquire another ultimately boils down to compelling valuation. In other words, the financial markets resemble Kmart and the target companies are on blue light special. So what does an acquiror consider when deciding on whether to make a bid on a target and more importantly, determine that the valuation is attractive? Consider the following checklist:

-Target’s cash on hand. Cash rich companies are attractive. The cash they have on their balance sheets can offset some of the acquisition costs. Additionally, the cash can be used to fund further expansion efforts later.

-Tax benefits. Here is where things can get complicated. In a nutshell, a target’s tax credits could be used to offset the acquiror’s tax gains, which could lower the overall acquisition price.

-Expansion. A target’s customer base or product suite may provide an acquiror with an effective platform to expand into a new market.

-Competition. If you can’t beat ‘em, join ‘em. Sometimes the best way to win a battle is to join forces with your enemy. After all, in business you only really win when you maximize profits.

These are just a few considerations that factor into the M&A decision model. In theory, they help the acquiror determine whether the target’s price is attractive.

Each quarter, earnings season sparks interest in corporations large and small. Analysts eagerly await the financial overview offered by senior managers by way of conference call. The managers cover general strategic developments followed by a detailed review of the income statement. Sales, costs, expenses and earnings are closely examined with the final performance tally culminating in net earnings. Unfortunately, these calls tend to downplay, if not ignore, the cash flow statement. Given the economic challenges facing companies today, the cash flow statement may prove to be a useful performance indicator for the company and more specifically, the management team.

The cash flow statement details the amount of cash generated from a company’s operations, investing activities and financing activities. In other words, it addresses the company’s ability to generate cash segmented by various business activities. It can indicate whether the cash is a product of a growing business or clever financial engineering. And most of all, it often serves as a good indicator of solid business management. When a company effectively generates consistent cash increases from business operations while deploying cash judiciously for growth related initiatives, it signals a management team on the right track.

It’s hard to ignore the headlines. The S&P credit downgrade of US government debt has clearly shaken the financial markets. But does it really matter? Unfortunately, credit ratings do matter in that the perception of weakness can often become a reality.

The recent downgrade will likely cause interest rates to increase, which affects consumers and businesses. At a time when the economy is on unstable ground, even a slight increase in interest rates can ripple through the economy by raising borrowing costs. Corporations will pay more to service corporate debt and consumers will pay more on their credit cards and mortgages. Given that austerity is all but a foregone conclusion, rising financing costs could force further cutbacks.

Now, the fear factor. If investors believe these things could happen, they start selling stocks. An increase in corporate financing costs and a cutback in consumer spending can mean one thing: a drop in corporate profits. And nothing drives corporate valuation, and in turn stock price, more than profits. Of course, all of this is based on what can happen when fear takes grip of the financial markets. The hope is that cooler heads will prevail and the real impact of a credit downgrade will be muted. Stay tuned…

In today’s challenging business environment, inventory management distinguishes the good companies from the bad ones. Business managers often turn their attention towards inventory in an effort to control their working capital. Inventory turnover represents the number of days it takes for inventory to convert to sale. This is an important metric because inventory is costly. It takes up space, requires financing and grows stale. The longer a company holds onto it, the greater the cost. Consider a company that turns over inventory four times per year. On average, the company would take three months to sell each item. If its competitors turn over inventory 12 times per year on average, they would possess a significant cost advantage. Companies such as Dell, Wal Mart and Toyota have done a superior job managing their inventories which has reduced costs and ultimately increased profits.

Attend our Accounting and Financial Statements course in person or online to learn more about inventory management as well as other methods of working capital management.

The IPO (initial public offering) market is showing signs of life with several high profile deals scheduled to launch in the coming weeks. After a multi-year slump, a rebound of sorts is in the works. Company managers are tapping into an equity market as strong as it has been since the start of the Great Recession. While a public offering provides some compelling benefits to a company, it’s not all fun and games. Let’s consider the pros and cons of going public:

Pros

1. Access to additional capital — Without access to public investors, a private company must raise funds from private equity investors and venture capitalists, who typically require a much higher return than do the public equity markets. Plus, once a company has gone public, it can continue to access the equity markets for additional capital.
2. Prestige — For corporate managers, a public company is the gold standard.
3. Proxy for value — The market value of a public company is easy to determine by multiplying the total shares outstanding by the share price.
4. Compensation — Stock grants and stock options can become a convenient way to compensate key employees.
5. Acquisition — A company can expand by acquiring other companies through stock swaps.

Cons

1. Regulatory requirements — All eyes are on the policies and procedures of a public company. It is estimated than a public company spends, on average, $1.4 million per year just to be in compliance with Sarbanes-Oxley.
2. Reporting — Managers often find themselves spending more time producing financial statements than developing strategies.
3. Subject to market forces — A good company can experience a significant drop in value due to a global event.
4. Pressure from Wall Street — Public companies live and die by their quarterly numbers and more importantly, their ability to impress Wall Street analysts.
5. Cost — The costs of going public can range from $500,000 to well over $1 million, so it makes sense to weigh the options.

Going public is not what it used to be but when timed well, it can create significant benefits for a company.

In a recent article, we discussed the structure of what’s known as the call option. As we discussed, call options are essentially contracts to purchase a certain number of shares of a stock at a certain price, within a certain amount of time. When the price of the stock increases, the value of the call option generally increases as well. We saw that the advantage of holding a call option is that it allows you to capture the upside of a stock’s upward movement with less capital and minimal downside. So what if we believe that a company’s stock price is going down? How can we protect ourselves or, profit from this downward movement? We buy a put option. Put options, like call options, are contracts that allow the holder to profit from the movement in an underlying stock (or other security).

Let’s imagine that our favorite company, Bailout Industries, has fallen on hard times. Its stock is trading at $10/share and you believe it could drop to as low as $5/share in the next year. You currently own 100 shares of Bailout stock and are concerned that if you hold on to it, you could lose half your investment. In order to protect this position, you buy put options. The December 2010 $10 put option is currently selling for $2. In other words, a contract to sell one share of stock at $10 before December of 2010 is priced at $2. If the stock drops to $5, your put option will appreciate in value. At expiration, it will be worth $5 (the $10 you would sell it for minus the market price at that time). So while you lost value on the stock position, you gained value on the put option position. The put option was essentially an insurance policy against a drop in stock price.

The problem with put options is that if the stock price stays flat over the next year, you would lose the $2 premium that you paid for the option. In other words, you had to pay the equivalent of 20 percent of your position just to protect it! For some, giving up something to have this kind of protection is well worth it. Of course, to break even, their stock will now have to appreciate by 20 percent.

Learn more about these and other useful concepts at our many upcoming webinars, local seminars, and on-demand programs.

With all the talk about swap regulation these days, we can’t help but ask, “what the heck are swaps?” Swaps are financial instruments used either to hedge against risk or to profit through speculation. Like other types of instruments of this sort, called derivatives, they are simply contracts between two parties, and their value is derived from the underlying security or market index on which the contract is based. Some are based on movements in interest rates, currency exchange rates or commodity prices.

A common swap is the interest rate swap. Consider a company that issued floating rate bonds - they have essentially borrowed money at a rate of interest tied to some interest rate benchmark such as LIBOR or prime. The company that issued the bonds is at risk of paying more to service its debt if interest rates were to rise. In order to protect itself, the company could structure a swap agreement allowing it to swap its floating rate payments for a higher fixed rate payment. It has removed the variability and risk of the floating rate bond. Essentially, the company has found a simple way to refinance its debt.

These days, there is a great deal of discussion on swaps because they have been virtually unregulated for many years. The concern is that without proper guidelines for valuation and disclosure, companies and the investing public are at great risk as corporations and investment houses use swaps on a regular basis. Stay tuned…

We hear about Silicon Valley executives who pocket millions when they leave their companies or Wall Street traders who make a killing when the stock market moves a few points. What alchemy creates such unbelievable returns? The answer: stock options. Stock options are essentially contracts to buy or sell shares of stock at a certain price, within a certain amount of time. Options to buy stock are known as call options and options to sell stock are known as put options. In this article, we’ll review the basics of the call option which allows an investor, trader or even the fortunate executive in a company to profit from the upward movement in a company’s stock price.

Suppose you are interested in investing in Bailout Industries. Their stock is currently trading at $10 per share and you believe it could go as high as $15 per share in the next year. In order to buy 100 shares of Bailout stock, you’ll need to shell out $1,000. If the stock were to reach $15, you could sell the stock for $1,500 and pocket a cool $500 profit. Now, consider what can be achieved if you buy the call options. The December 2010 $10 call option is currently selling for $1. In other words, a contract to buy one share of stock at $10 before December of 2010 is priced at $1. With $1,000, you could buy 1,000 call options. So what happens if you buy the call options and the stock does reach $15 next December? Your position is now worth $5,000! Not bad for a $1,000 investment. Sound too good to be true? Well, it can be.

The problem with call options is that they are simply contracts. When the terms of the contract are not met, they are essentially worthless. If Bailout stock falls below $10 and remains there at the time of expiration, the options are worthless and you’ve lost your $1,000. In future articles, we will take a look at put options and option valuation.

Recently we discussed the Comparable Multiple method of valuation. In this article, we will take a look at the more complex Discounted Cash Flow (DCF) method of valuation.

The DCF method is based on the idea that a company, or any asset for that matter, is valued based on its future cash flows (or some variation of cash flow). In other words, an asset is worth the aggregate of what it produces over time. In theory, this makes sense. If you buy a beach house and plan to rent it, the value to you is based on the future rental payments. A factor that must be addressed, however, is that because of the time value of money, which we talked about in a recent article, future payments are worth less in today’s dollars than their nominal value when they’ll be received.

So what does all of this have to do with the DCF method of valuation? In a DCF model, all projected future payments are discounted using a fairly simple formula to determine present values (in today’s dollars). The more complicated part is determining the discount rate to use, and this is often very subjective. We’ll usually take into account a variety of variables, including the company’s financing costs, historical volatility of the stock price and historical returns of the stock market to name a few. Depending on which assumptions are used, the resulting values will vary considerably. Additionally, the entire model is built on the premise that a company’s value is based on its future cash flow (or some variation of it). This implies that the analyst who produces the model is capable of predicting the future. One thing the financial community has taught us is that no one can truly predict the future. So just as with the Comparable Multiple method, valuation is more art than science.

Telestrat offers valuation courses in several forms, including live online, on-demand, and in-person in major cities across the U.S. Learn about the most common valuation methods, including a number of variations, as well as the underlying concepts. We also offer many other accounting and financial courses, all taught by seasoned professionals with the rare ability to distill seemingly complicated concepts into a simple, understandable form. Sign up today!