How to value companies

Friday, 22nd December 2017 14:51 - by Eric Chalker

   It is not unusual at Christmas time to come across book recommendations, but probably not to see one recommending a book on accountancy.  Even so, this is the subject today – recommended reading for those who would like to be better investors.  The book is “Accounting and Business Valuation Methods,” written by a leading member of the UK Shareholders’ Association, Malcolm Howard.

   In his book, Malcolm Howard explains that, although what might be called a standard portfolio may well include some exceptional investments, it is likely also to include one or more loss-making disasters.  He demonstrates that some potential disasters can readily be avoided, thus substantially improving returns.  

   He naturally applies his understanding of company accounts and the strength of their earnings in making his own investment decisions, so he aims to invest in relatively low risk stocks – that is, companies generating profit and cash with little or no debt.  Despite this causing him to avoid the AIM-listed companies which some investors think are the only means of getting rich, he tells me that his ten year return, including reinvested dividends, is 320 per cent.  This equates to a compounded annual return of 15.5 per cent, which certainly more than justifies his approach.

Assessing the book

   The book will not be everybody’s cup of tea.  It has been written for two, very different, but specific readerships.  On the one hand it is for students of accounting, but “in addition” says the author, “it is designed to help readers with entrepreneurial spirit to understand the financial challenges they will face when they start a business and how they might make profitable investments after they have been successful.”  Apart from some very informative, real life, case studies at the end, plus an alphabetic index, there is a business story running through the book which helps to make the book interesting and relevant to investors.  There are though, it has to be said, many pages of figures in the book to illustrate the story, which some will choose (as I did) to bypass, lacking the time or motivation to take on board so much detail (unlike accountancy students, one assumes).  Each of the four chapters also ends with ‘discussion questions’, clearly intended for students.

   It is of course not possible to read a book which sets out to explain figures without spending some time looking at those figures, but by limiting that to what seemed necessary to understand the narrative and concentrating mainly on the narrative itself, I still found the book of value.  Having run my own business I was not wholly ignorant of the subject matter, but reading the book increased my knowledge and understanding.   Of particular importance, the book helpfully reminded me of things to which I should have been paying more attention and thus avoiding losses.  On top of that, it will always be a helpful reference book when trying to understand company accounts and I know it will also repay re-reading from time to time, especially the final chapter on assessing risk and valuing companies.

   Among his colleagues, the author is a noted critic of the International Financial Reporting Standards (IFRS), but the book is evenly written in a straightforward manner that takes things as they are.  Strong emphasis is placed on the basic tools of analysis (ratios) which can be used to measure a business and compare it with others for valuation purposes.  The author lists more of them than the average investor will probably want to use, but even to read through them is a worthwhile process, as it educates and alerts the reader to tools that are always available.

Key business ratios

   First are performance ratios, to measure growth probabilities: turnover compound growth, gross profit percentage, gross profit compound growth, operating profit percentage, operating profit compound growth and return on capital employed.

   Then come asset management ratios, to show how well under control are the company’s assets: current ratio, quick ratio, stock days and debtor days.  These are followed by structure ratios – to assess how likely the business is to meet its cash obligations: interest cover, gearing and debt to equity. 

   Lastly we have investor ratios, for judging the equity value: return on equity, earnings per share, price/earnings ratio, dividend yield, dividend cover and goodwill built into a share. 

   For Malcolm Howard, “cash is king”.  His primary test of a business is whether net cash inflow from operations exceeds operating profit.  If it does not, the reason must be found or deduced from other information in the accounts, primarily stock days and debtor days and how those ratios compare with previous periods and other companies in similar types of business. 

   All of the foregoing leads to the final chapter, ‘Assessing risk and valuing companies’.  Its section headings include risk, portfolio theory, assessing company performance, valuation techniques, why the market sometimes gets it painfully wrong, profit warnings and takeover bids.  This is perhaps the most important chapter for investors, which could perhaps be read on its own but the previous chapter’s information about ratios should not be overlooked.  There is much value here, for those prepared to study what Malcolm Howard has written.

Additional information

   Malcolm Howard spent much of his working life as an accountant in industry, but he has also lectured at the University of Surrey on financial management.  In the former role he organised a management buy-out.  In the latter role he devised a course on ‘Entrepreneurial Business Development’ which was sponsored by 3i Group plc.

   The book had its first edition in 2008.  It is published by CIMA Publishing, which is an imprint of Elsevier.  Copies are available via the internet, from Amazon and other sources.  I paid £39 for my copy last June, including postage and packing.   

   One of the book’s distributors describes it as, “an excellent platform of knowledge to go on to discuss the basic tools of analysis, reviewing market valuations and market to book ratio and assessing the balance sheet, valuing companies, and much more.”

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.