Chapter 22

A stock market analysis of a firm should be performed after having checked the liquidity of the stock and understood the shareholder base. It is centered on stock market performance which should be compared to the financial performance of the firm, multiples (especially P/E), dividends and returns, compared with required returns.

Dividends are analysed by looking at returns (dividend on the share price) and the payout ratio (dividend on net profit).

The P/E (price to earnings ratio) is the ratio of the value of the share to EPS (earnings per share). Changes in P/E follow future EPS growth and move in the opposite direction from interest rates and risk (financial and operational).

It is only when the company pays out all of its profits and when financial and industrial markets are in equilibrium that inverse P/E (also called earnings yield) is equal to shareholders' required rate of return. Generally, the inverse P/E criterion results in an underestimation of shareholders' required rate of return.

The EBIT multiple is another valuation multiple, which is computed as enterprise value (i.e. value of debt and equity) divided by EBIT.

It should be noted that a stock market analysis should be performed only after the market price has been adjusted for certain past transactions, (stock split, rights issue); certain future events (conversion of convertible bonds, exercise of warrants or stock options) can also be taken into account.