Four numbers that let you read a share: market capitalisation, PE, price-to-book, asset turnover

Hook

A question for you. Two companies. The first, fifty ringgit a share. The second, fifty sen a share. Which is bigger? Most people point at the first. Wrong. This episode is four numbers. The first one will already tell you why a share price, looked at on its own, tells you nothing.

Market capitalisation: what a company is really worth

First number: market capitalisation. Market capitalisation is the share price, multiplied by the number of shares in issue. Back to those two companies. The first is fifty ringgit a share, but it has only ten million shares — a market capitalisation of RM500 million. The second is fifty sen a share, but it has ten billion shares — a market capitalisation of RM5 billion. The second is ten times bigger. The share price is only the result of how many slices the whole cake was cut into. Cut it finely and each slice is cheap; cut it coarsely and each slice is dear. How big the cake is, is market capitalisation. So next time you hear "this share is only a few sen, it is very cheap" — mathematically, that sentence means nothing.

PE: the one bosses ask about most

Second number: the price-to-earnings ratio. The arithmetic is simple: share price, divided by earnings per share. You can also look at it as market capitalisation divided by net profit. The reading is simpler still: at the current rate of earning, how many years it takes to earn back what you paid. A PE of twenty is twenty years. Then a boss will always ask: is a high PE a good thing? No. And a high PE has two completely opposite causes. The first: the market thinks it will earn more in future. What you are paying for is the future. That is optimism. The second, and this is the one most easily missed: the denominator collapsed. The company's profit fell hard, the share price has not finished falling — and the PE flew up on its own. What you are looking at is not optimism, it is a business in the process of breaking. Same number, two opposite stories. So when you see a high PE, the first thing to do is not to judge it good or bad. It is to go back and look at whether its earnings over the last three years have been going up or down.

So what actually counts as paying too much

There is no absolute number that says expensive. There are only three comparisons. First, against its peers. Within the same industry, roughly where do everybody's PEs sit? Normal levels differ enormously between industries, so comparing across industries is comparing nothing. Second, against its own history. Over the past few years, what range has this company's PE spent most of its time in? Is it at the top of that range now, or the bottom? Third, against growth. A company whose profit grows quickly every year can reasonably carry a higher PE; a company standing still has no claim to the same level as a growth share. And there is a trap the person keeping the books sees first: the company sold a piece of land, net profit jumped this year, and the PE suddenly looks very cheap. Next year there is no land to sell. So look carefully first: did that profit come from the trade, or from selling something? This is what we said in the episode on accounting policy — look first at where the number came from.

Price-to-book: who it helps and who it does not

Third number: price-to-book. The share price divided by net assets per share — which is market capitalisation divided by shareholders' equity. In plain words: how many times book value is the market willing to pay for the pile of things it owns? This number is useful for asset-heavy businesses — banks, property, shipping, plantations. The assets are their means of production. For asset-light businesses it is of very little use — software, consulting, services. The most valuable things they have are people, customers and brand, and those were never on the balance sheet in the first place. And one more thing to be clear about: a price-to-book below one does not mean you have found a bargain. It is the market saying that this pile of assets does not earn what it should, or that the book value was overstated to begin with. To work out which, you have to open up the assets and see what is actually inside — and that takes us back to the chart of accounts episode: with a messy chart of accounts, every ratio is a fiction.

Asset turnover: the only one you can work out yourself

Fourth number: asset turnover. Revenue, divided by total assets. How many ringgit of business does one ringgit of assets do for you in a year? This is the most useful of the four, because it does not need a share price. You are not listed and you can still work it out — just open your own accounts. Your peers do two ringgit of business on one ringgit of assets and you only do eighty sen. The problem is usually not your selling price. It is that you are feeding a pile of assets that do not earn for you: stock that will not move, receivables that will not come back, idle machinery, premises you bought and never used. This one number you can work out for yourself tonight.

How all this affects what a major shareholder is worth

Finally, string the four numbers together. What a major shareholder is worth equals shareholding percentage, times market capitalisation. Two variables. So there are two roads to making yourself poorer: the market capitalisation shrinks, or — and more people come unstuck on this one — your percentage is diluted. Let me show you the arithmetic. Suppose the company is worth RM100 million and you hold seventy per cent: you are worth RM70 million. The company issues new shares to raise money, and the market capitalisation rises to RM120 million — up twenty per cent, good news. But your shareholding has been diluted to fifty-five per cent. What you are worth: RM66 million. The company got bigger and you got smaller. This is not something peculiar to listed companies. Every time a new shareholder comes in, every time capital is raised, the same arithmetic is being done.

To close

Four numbers: market capitalisation, PE, price-to-book, asset turnover. Listed companies are assessed this way every day. And one day, when a bank, a buyer or a partner assesses your company, they will use the same set. There is only one difference: they can see the numbers of a listed company, and whether they can see yours depends on the state of your books. Want to know what your company looks like on these four numbers? Grab a coffee first and talk about your business. For the accounting, come to LTT. I am LTT, helping SME bosses get their accounts straight. Follow us, and see you next time.