The easiest way to start thinking about the value of the company is to calculate how quickly such an investment would pay off (in English, this indicator is called "price earnings ratio" or PE ratio). To estimate it, simply divide the company's stock value by the last year's earnings. If it is assumed that the profit of the company will not change in the future, this indicator shows how many years the company will earn back the amount that has been used to buy these shares.
For example, the fuel and other energy resources trader Virši, listed on the NASDAQ Baltic exchange, worked with a profit of EUR 0.69 per one company share in 2022. On the other hand, the share price on February 28, 2023 was EUR 4.45. Dividing both values, it follows that Virši investors, who would buy the company's shares now, would recoup their investment in 6.45 years. But is the payback in 6.45 years good or not? For comparison, at the beginning, you can calculate what the following rate of return is for some other stocks traded on the stock exchanges of the Baltic countries:
According to this calculation, the investment of Madara Cosmetics will pay off for investors in more than 50 years, while HansaMatrix will "eat" the loss of the entire investment in 7 years. On the other hand, the energy company Ignitis Grupe, which formally works in the same sector, offers a twice shorter payback period than Enefit Green. If you do not want to calculate this indicator yourself, then this value is calculated as "Price/Earnings" on the NASDAQ Baltic website for each company in the Fact sheet section. If the ratio is marked TTM (trailing twelve months), it means that the company's profit in the last 12 months, not the calendar year, has been taken into account.
By comparison, the average payback period of companies included in the Standard&Poors index of the 500 largest companies of the US stock exchange is about 20 years, while the average payback period of the largest companies of the NASDAQ technology companies is around 25 years.
Payback Years, S&P 500 Index, US (Last 10 Years)
The payback ratio can be a useful tool for quickly determining how a company is valued compared to its more direct competitors or the industry as a whole. Average returns for each sector are easy to find for the US stock market. For example, as of January 2023, the average score for biotech companies in the US was 81, while for woodworking companies it was 9. Payback years within the same industry usually do not differ much, and therefore this indicator is usually used to determine how a company is valued compared to other players in the industry. The main advantage of this ratio is its ease of calculation and convenience to use it as a benchmark for comparison with other similar companies.
In turn, these are some of the main limitations of the payback period ratio:
- Subjective interpretation. It does not calculate the value of the business, but indicates what other investors are willing to pay for the business right now. How to evaluate it, whether the calculated indicator indicates a good company price or a bad one, is again up to each individual investor;
- Limited view. Not suitable for loss-making businesses. Does not take into account dividends, financial obligations of the company, actual cash flow, historical or future growth prospects of earnings and many other financial factors;
- May lead to false conclusions. Just as no two people are identical, no two businesses are exactly the same. There may be very good reasons why companies in the same industry may have completely different payback rates.
Accordingly, the payback years indicator has its advantages and a number of disadvantages, so it is worth using it for purely indicative and generally comparative purposes. Why are there such differences between the payback years of industries and companies and what are they justified by? Why is it better to buy Madara Cosmetics shares with a 53-year payback period than a rental apartment? More on this in the next article, where we will look at how the share value is affected by the company's profit growth.
* The picture of the article is from the publicity materials of Madara Cosmetics, SIA