Three benchmarks for market value

Premier Foods' earnings yield is 15% if you divide earnings by price conventionally,  6% if you divide earnings before interest and tax by enterprise value, a method popularised by Joel Greenblatt, or 7% if you multiply median return on capital by how much you’re paying for the capital, the method I chose when I evaluated the company.

Which is best?

An earnings yield of 15% suggests that investors buying at the current price might expect a return, paid or reinvested in the company of 15%, which makes the shares look cheap (it’s the same as a price earnings ratio of just under 7). A yield of 6% (close to a PE of 17) is much less appealing.

The difference is debt. The basic earnings yield calculation ignores debt. More elaborate measures add it to the price of the company to give enterprise value, the price a buyer might pay for the whole business including the cost of repaying the debt. With no debt to pay, the earnings figure need not be encumbered by interest so the denominator in the Greenblatt earnings yield calculation is EBIT, or earnings before interest and tax.

I don’t think investors should ignore debt in determining the market’s valuation of a company because a company can easily get itself into more debt, and, perhaps with more difficulty, pay it off, which has implications for future earnings, and therefore the current value of the company. The higher the future earnings, the more valuable the company is now.

The basic earnings yield fails to recognise the potential in a company with little debt, and overestimates the potential in heavily indebted ones. Companies with ample resources can invest or return capital to shareholders, probably increasing future earnings. Companies like Premier Foods (which is struggling to pay the interest on its debt), must (literally, at the behest of its bankers) reduce investment to pay off debt, potentially reducing earnings.

If future earnings are likely to be higher than past earnings, the earnings yield, which is based on past earnings will undervalue the company. Likewise, if future earnings are likely to be lower, the earnings yield will overvalue it.

By using a measure like the earnings yield investors are thinking something like: "If earnings in the future are like they were last year, an earnings yield of X% is the return we might expect", but that’s not true if the company will be operating with a different level of debt in future.

Premier Foods will be, so I used Greenblatt’s method of calculating the earnings yield, with a couple of adaptations. The last calculation, which I have inelegantly dubbed the ‘long term post-tax earnings yield’, reincorporates corporation tax to give a truer estimate of the yield shareholders might typically receive. It also uses average returns, rather than relying on a company’s most recent, and possibly anomalous, results.

I’m thinking "If the business had no debt, this is the kind of return I might expect to receive."

It’s unlikely Premier will repay all its debt, most prosperous businesses can sustain some, so my earnings yield is too pessimistic and the truth may well be somewhere between 6% and 15%. The size of that spread, though, is an indicator of how speculative any such calculation would be. Since Premier’s tangible book value is negative, pinning a valuation on the value of its assets instead of its future earnings is also speculative, so I decided the company was too much of a gamble for the Thrifty 30.

Notes:

• How I calculate the earnings yield
• Premier Foods in 2 minutes 11 seconds