Price To Earnings (P/E) Ratio
The P/E ratio illustrates the relationship between the current market price of a company’s shares and the profits that the company generates. A lower P/E ratio is an indication that the price of a company’s share is lower in relation to the overall profits of the business and thus that the company may provide a better option for investment (depending on variables such as the industry average). Potentially profitable companies in their early stages may not have generated much (or any) profit, which would give rise to a low earnings per share figure. As such, the P/E ratio may be more useful for comparing or valuing more mature companies.
Combined Value
An investor could consider the additional value a target company could bring to their existing business. Does the target business complement their existing business in a manner that could increase the overall value of the newly combined company post-combination? Could a merger help an investor to reduce costs (through enabling greater economies of scale or boosting their bargaining power with suppliers); acquire complementary skill sets and expertise; reduce competition; or increase their overall influence in the market? If so, an investor may be willing to pay a premium in order to acquire another business.
Comparable Analysis / Precedent Transactions
Investors would likely also take into account the prices that have been paid for comparable businesses (for instance businesses that are similar geographically, in size or operationally) under comparable circumstances.
Future Potential Of The Business
Investors could consider the overall prospects of the market in which a business operates and whether any opportunities are likely to arise that will boost profitability. For instance, if a sports equipment chain in London is the subject of a valuation and investors are aware that the Olympics are set to commence in the near future, they may be willing to pay a greater amount for the business in the knowledge that sales are likely to significantly increase during and after the Olympics. Growth projections for similar products, businesses and industries may also be taken into account. Investors could consider where a target business’ products are at in the product life cycle. Do the products have the potential to sell at a similar rate to that which has generated current profitability levels, or will sales likely diminish? For instance, if a patent belonging to a target business is about to expire, competitors may be able to subsequently copy and sell the technology themselves, attracting customers away from the target business.
- Product Life Cycle: the period over which a product enters and eventually exits the market. The number of sales typically increases after a product is released and initially marketed. The number of sales then tends to stabilise and eventually diminish as more competitors enter the market and the product is replaced by cheaper or superior alternatives.
Intangible Resources
Consider whether the target business has formed political, social or commercial relationships that could be beneficial. Take into account the value of human capital. For instance, does the business have a unique management team that affords it a competitive advantage?
. . .
By Jake Schogger - City Career Series