Still fresh in memory are stories of how thousands of investors lost over N6 trillion in the stock market crash of 2008 and the spinoff decline that further wasted their wealth in the next four years.
The sad experience of investors in equities on the Nigerian Stock Exchange (NSE) makes it necessary to do shareholder value analysis (SVA) before investing. This helps to avoid losses.
Sophisticated as SVA may sound to an ordinary investor, it helps to determine a company’s return on investment (ROI) and whether it is worth the while to invest in its shares.
What to look out for
An investor without the technical know-how should critically examine the capital appreciation of the stock over a period of two years, at least.
• Consider the dividends and/or bonus culture of the company; whether stockholders are getting such returns at regular intervals. Only a company that is doing well awards dividends and bonus shares.
• Think about the price of the stock and determine how well it is doing in price appreciation or depreciation, and its key drivers over two years.
• Determine the volume of shares in issue as this helps to make or break the quality of returns in terms of price earning (PE) ratio. Companies with large volumes of share capital often offer stockholders miserable returns and vice versa.
For companies with a weird volume of shares outstanding, shares reconstruction may be an option in the near future. In a bearish market where share prices are tumbling, reconstruction of shares may wipe out half the value of stockholders’ investment.
All said, before taking the plunge into equities investment, it is advisable to do a shareholder value analysis so as to have a fair estimate of what returns to expect at the end of every year, all other things being equal.
For every investor, the objective of a company’s directors and management is to maximise the wealth of stockholders by consistent improvement on the return on investment (ROI).
Stock analysts believe that if a company’s operations cannot generate net earnings at a rate that exceeds the cost of borrowing funds, the future of that company is bleak.
Return on investment calculator
An investor can work out a company’s ROI and determine whether it is worth investing in.
Here is the basic ROI formula applied by some investors
• Divide net profit by total investment and multiply by 100 to arrive at a percentage ROI.
• ROI = net profit/total investment x 100/1.
• If net profit is N30 million and total investment N250 million, ROI is 30/250 = 0.12 x 100 = 12 per cent.
A variation of the basic formula sometimes is the SVA. This calculates the value of a company by looking at the returns to shareholders using the formula below.
• Estimate total net value of company based on present and future cash flows and divide the figure by the value of its shares. The resulting figure is the company’s value.
Once the amount has been calculated, targets for improvement can be set and shareholder value can be used to measure performance.
Value drivers
In his book, Creating Shareholder Value, Alfred Rappaport identified seven key value drivers of a company as sales growth rate, operating profit margin, income tax rate, working capital investment, fixed capital investment, cost of capital and value growth duration.
A company’s value to shareholders is calculated by subtracting the market value of debts from the total value of the company.
Total business value has three main components: present value of future cash flows during planned period, residual value of future cash flows from a period beyond the planned period, and weighted average cost of capital.
This is calculated by adding present value of future cash flows to the residual value of future cash flows and dividing it by the weighted average cost of capital.
If the result of this equation is greater than one, the company is worth more than invested capital and added value is being created.
If the assets of a company cannot earn the required return, investors withdraw funds from it and that marks the beginning of its end.
