Chapter 5
Earnings-Based Value

Earnings are affected by many factors, including marketing investments. Understanding the mechanics of earnings-based value will help marketers recognize the connection between their marketing activities and company earnings. This is important for publicly-traded companies since shareholders want the value of their investment to increase, and earnings are instrumental in determining share price.

Publicly-traded companies are evaluated on the performance of their stock, since it is a direct measure of value creation (or destruction) for investors. Earnings-based value is a series of calculations that help assess the value of a company and, indirectly, suggests the impact of product and marketing investment decisions on market demand. It includes using several key financial variables: earnings per share (EPS), price/earnings ratio (P/E), price/earnings growth ratio (PEG), and the year-ahead price/earnings growth ratio (YPEG). Each of these metrics build from one to the next in order to determine final earnings-based value.

To facilitate a clearer understanding of earnings-based value, we must define earnings. Earnings are the same as net profit, and they are evaluated using EPS as follows:

Where

EPS = earnings per share

P = profits

So = shares outstanding

Next, we need to determine whether EPS is good, bad, or inconclusive. Earnings must be compared to the company’s share price using the P/E ratio. The P/E ratio is an indicator of a company’s growth and, indirectly, its value. The P/E ratio takes the stock price and divides its earnings from the past year (or four quarters):

Where

SP = share price

EPS = earnings per share

The result is called the multiple, and while it is an acceptable component measure value, it is incomplete and should not be relied upon as a determinant of overall financial performance. Companies with a low P/E ratio may appear to be a good value and worthy of investment, but the P/E ratio is based on past performance and is not a good indicator of future potential. Since managers and investors are looking for future growth potential, a low P/E could also be interpreted as a company with a poor chance for future success.

PEG Ratio

The PEG ratio compares historical earnings growth to the P/E ratio.

Where

PEG = price/earnings growth

P/E = price/earnings ratio

EPS = earnings per share (historical growth)

Theoretically, as long as your P/E ratio does not exceed your growth rate, your company is reasonably valued. A PEG of .5 to 1.0 is considered good or fair value, whereas a PEG of greater than 1.0 indicates the company may be overvalued. The PEG ratio is used by analysts when evaluating growth companies, which are defined as those where revenues and earnings are growing faster than the average company in the market.ii

YPEG Ratio

The YPEG ratio has the same basic assumptions as the PEG ratio, but incorporates projected future growth rates and not PEG’s historical earnings growth rates. YPEG is more commonly used to evaluate companies with lower rates of growth, which tend to be mature firms and/or companies in slower growth markets. Overall, the same logic applies to the PEG ratio: .5 to 1.0 is good and greater than 1.0 is a potential problem.

The YPEG ratio equals the current P/E ratio divided by the future earnings growth rate:

Where

YPEG = year-ahead price/earnings growth

P/E = price earnings ratio

EPS = earnings per share (future growth)

Illustration

EPS

A company called Good Forever (GF) has five million shares outstanding and has earned $2.5 million in the previous twelve months. GF’s trailing EPS is 50 cents:

$2,500,000

5,000,000 shares = .5

By itself, EPS is relatively unhelpful and only becomes more important as management includes it into the rest of the earnings valuation analysis.

P/E Ratio

Now we assume that GF has a stock price of $50 per share. Using the P/E ratio, we find:

The P/E is 100. If GF competes in a rapidly growing industry, such as sharing economy firms like AirBNB and Uber, then a P/E of 100, while generally considered high, may be normal for this market. However, it would also suggest an expensive company and stock.

PEG Ratio

Assuming GF’s historical growth rate is 25%, this gives us the following:

The PEG is 4.0. This indicates that GF is valued four times higher than it should be, thus it appears to be overvalued.

YPEG Ratio

Completing our GF illustration, but assuming that it is now a more mature firm and that growth is expected to be closer to 10% in the coming years, produces the following result:

The YPEG is 10.0, an indication of a significantly over-valued company in this case.

Earnings-based value is used to help managers and investors value a company, when comparing value to time, particularly as it relates to profitability. An increase in earnings-based value may indicate whether a company’s products are accepted in the market, if it can command premium margins, and if market share is growing profitably. However, one must recognize that earnings-based value does not directly describe these factors. Rather, it serves as an indicator of the underlying factors contributing to earnings performance.

Marketers have a responsibility to ensure their decisions result in positive growth, increased market awareness, and profitable product lines. Earnings-based values are complex and make certain assumptions that must be considered in the context of the company’s historical performance, that of its industry competitor set, and the future potential of the firm. Earnings-based values reflect only a subset of the potential value of a firm, brand, or product because businesses are more than an earnings stream. Earnings, in their simplest form, are merely a measure of value during a particular period of time and are not always correlated with examples of market success or failure, which can be frustrating to business leaders. Economics assumes a rational customer in many of its theories, yet in reality many customer decisions are the result of a unique alchemy of intuition, experience, and individual logic. Similarly, earnings-based valuations assume that the ideal world is one in which the P/E ratio and the EPS growth rate are equal, or should be very close to equal. However, there are numerous factors that affect the performance of companies and the perceptions of their products beyond the concept of fair value.

Publicly-traded companies include this information in their annual reports in the sections called “Notes to Financial Statements” or “Notes to Consolidated Financial Statements.”

iThe Motley Fool: How to Value Stocks: Earnings-Based Valuations. Retrieved May 9, 2017 from https://www.fool.com/how-to-invest/how-to-value-stocks-earnings-based-valuations.aspx

iiNasdaq, PEG Ratio. Retrieved June 6, 2017 from http://www.nasdaq.com/symbol/amzn/peg-ratio