Understanding Valuation: Overvaluation and Undervaluation

Before deciding whether to buy into Ethio Telecom, you need to grasp the basics of valuation. In simple terms, valuation is the process of determining how much something is worth. Think of it like buying a car. The sticker price tells you how much the dealer thinks the car is worth today, but whether or not it's worth that price is the tricky part.

When something is overvalued, it means the price is higher than its actual worth—like buying a flashy sports car only to find out the engine is a dud. On the other hand, if something is undervalued, it’s like discovering a rare gem hidden in plain sight—a car that performs like a dream but is priced far below what it’s truly worth.

So, how do you figure out whether Ethio Telecom is overvalued or undervalued? The answer lies in the company’s valuation techniques, and more importantly, how those numbers stack up against the bigger picture.

What’s Behind Ethio Telecom’s ETB 300 Billion Valuation?

Ethio Telecom has been valued at 300 billion Birr by Deloitte, based on two widely accepted methods: the income approach and the market approach. These methods give investors a comprehensive look at the company’s current value and potential for future growth. But what do they really mean?

- The Income Approach: This method estimates how much money Ethio Telecom is expected to make in the future and then discounts that back to its present value. Think of it like estimating how much rent you could charge if you bought a house and rented it out. The idea is to figure out what the company’s future cash flows will be, and then determine how much those cash flows are worth today. This gives us a sense of Ethio Telecom’s intrinsic value—the true value based on what it can generate over time

- .The Market Approach: This method compares Ethio Telecom to similar companies in the telecom industry, both locally and globally. It’s like looking at how much similar houses in the same neighborhood are selling for to determine if you’re getting a good deal. By comparing Ethio Telecom to other telecom companies, the market approach helps ensure that the valuation is reasonable in relation to its peers.

Now that we’ve got a handle on how the valuation was calculated, let’s break down what it means for you as a potential investor.

The ETB 300 Question: Overpriced or Just Right?

So, at ETB 300 per share, is Ethio Telecom offering a golden ticket, or is the company asking too much? To answer that, we need to look at a common financial metric used to assess whether a stock is over- or undervalued: the Price-to-Earnings (P/E) ratio.

What is the P/E Ratio?

The Price-to-Earnings (P/E) ratio is one of the most commonly used metrics to assess whether a stock is fairly valued, overvalued, or undervalued. It compares a company’s current stock price to its earnings per share (EPS). In essence, it shows how much investors are willing to pay for each unit of a company's earnings.

The formula for the P/E ratio is:

(P/E Ratio) = {Price per Share) / (Earnings per Share (EPS)

For example, imagine a company, "TechCo," whose stock is trading at ETB 100 per share. If TechCo earned ETB 5 per share over the past year (its EPS), the P/E ratio would be

P/E = 100/5 = 20

In this case, the P/E ratio of 20 means investors are willing to pay ETB 20 for every ETB 1 of TechCo’s earnings. But what does that actually tell you as an investor? Let's break it down further.

How to Interpret the P/E Ratio

- High P/E Ratio: A high P/E ratio can suggest that investors expect high future growth from the company. For example, if a company has a P/E ratio of 50, it means investors are willing to pay ETB 50 for every ETB 1 of earnings because they believe the company will grow its earnings substantially in the future. However, it could also mean the stock is overvalued, and if the company doesn’t meet these high expectations, the stock price might fall.

- Low P/E Ratio: A low P/E ratio could signal that a stock is undervalued, meaning the stock price doesn’t reflect the company's true earning potential. It might be an opportunity to buy a stock at a bargain. On the flip side, a low P/E ratio could also indicate that investors are pessimistic about the company’s future prospects and expect earnings to decline.

Real-World Example: Safaricom’s P/E Ratio

Let’s take the example of Safaricom, Kenya's leading telecom company. Suppose Safaricom’s stock is trading at KES 25 per share, and the company’s earnings per share (EPS) over the last year were KES 1.32. The P/E ratio would be:

P/E = 25/1.32 = approx 18.9

This means that investors are willing to pay KES 18.9 for every KES 1 Safaricom earns. Now, let’s say the average P/E ratio for telecom companies in Africa is around 18 to 20. In this case, Safaricom’s P/E ratio falls within the typical range for the industry, meaning investors consider it fairly valued based on its earnings potential.

However, if Safaricom had a P/E ratio of 50, it would indicate that investors are highly optimistic about its future earnings growth. On the contrary, if the P/E ratio were only 10, it could suggest that investors are less confident in its future performance or that the stock might be undervalued.

Ethio Telecom: A Closer Look at Its P/E Ratio

Based on Ethio Telecom’s net profit of ETB 19 billion in 2024, the company’s P/E ratio is about 15.8 (calculated by dividing the ETB 300 billion valuation by the ETB 19 billion profit).

P/E = 300/19 billion = 15.8

This means that investors are paying ETB 15.8 for every ETB 1 of Ethio Telecom’s earnings. Compared to other telecom companies in Africa, like Safaricom (P/E of 18.9) and MTN Group (P/E of 17), Ethio Telecom’s P/E ratio is slightly lower. How does this stack up? Well, telecom companies in Africa typically have P/E ratios in the range of 18 to 20. For example, Safaricom in Kenya trades at a P/E ratio of 19, and MTN Group, another major African telecom, has a P/E ratio of around 17.

What Does Ethio Telecom’s P/E Ratio Tell Us?

This suggests that Ethio Telecom may actually be undervalued. Compared to its competitors, the company’s shares are priced lower in terms of earnings, which could indicate that there’s room for growth. It suggests that investors are not pricing in as much future growth for Ethio Telecom as they are for companies like Safaricom and MTN. If the company continues to increase its revenue and profits, early investors could stand to benefit significantly.

However, this lower P/E ratio might also reflect specific risks or challenges associated with Ethio Telecom, such as competition, regulatory hurdles, or uncertainties about its performance once it transitions to public ownership. Investors might be cautious, especially given that Ethio Telecom is part of a relatively new and untested stock market in Ethiopia.

But if you believe in Ethio Telecom’s growth potential and think it will outperform expectations, the lower P/E ratio could mean you’re getting in at a bargain price. In this case, you’d be buying shares with the hope that as the company grows and its earnings increase, the stock price will rise accordingly, allowing you to benefit from the value appreciation.

Other Factors to Consider Beyond P/E

While the P/E ratio is a useful metric, it’s not the only factor you should consider when evaluating whether to invest in Ethio Telecom (or any company). Here are a few additional points to keep in mind:

1. Growth Prospects: Does Ethio Telecom have a clear path to grow its revenue and earnings over the next few years? Look at factors like the company’s expansion plans, market share, and competitive landscape

2. Industry Trends: How does the broader telecom industry in Ethiopia and Africa look? Are there technological shifts (like 5G) or regulatory changes that could impact the company’s future profitability?

3. Debt Levels: Does the company have a manageable level of debt, or is it weighed down by excessive borrowing? High levels of debt can erode profits and limit growth potential.

4. Management and Governance: Is the company led by experienced and capable managers? Strong leadership can make a big difference in a company’s long-term success.

5. Macroeconomic Factors: Ethiopia is undergoing significant economic changes, including the liberalization of sectors like telecommunications. How will these changes impact Ethio Telecom and its ability to compete and grow?

But There’s More to the Story…

Before you get too excited about the prospect of buying shares in Ethio Telecom, there are a few key factors to consider that could affect your investment decision. Let’s take a closer look at some of the risks and opportunities involved.

1. Liquidity: Can You Cash Out When You Want?

One of the biggest challenges with pre-IPO investments is liquidity. Unlike publicly traded stocks, which you can easily buy and sell on a stock exchange, pre-IPO shares often can’t be sold until the company goes public. This means that if you buy Ethio Telecom shares now, you might have to hold onto them for a while, potentially years, until the company lists on the Ethiopian Securities Exchange (ESX). If you’re not prepared for a long-term investment, this could be a major downside.

2. Information Asymmetry: Are You in the Know?

Another potential risk with pre-IPO investments is the lack of publicly available information. Publicly traded companies are required to disclose a lot of information to investors, but pre-IPO companies like Ethio Telecom may not be as transparent. This creates a situation known as “information asymmetry,” where you might not have access to all the data you need to make an informed investment decision. Conducting thorough research and due diligence is crucial here.

3. Market Sentiment: What Do Other Investors Think?

Even if Ethio Telecom is undervalued today, its stock price in the future will depend on more than just the company’s financial performance. The price of shares after the IPO will be heavily influenced by market sentiment—how confident other investors are in the company’s prospects. Factors like news about the company, developments in the telecom sector, and broader economic trends can all impact investor perception. Positive buzz could send the stock price soaring, while negative sentiment could drag it down.

4. The Ethiopian Market: Navigating Uncharted Territory

As Ethiopia’s stock market is still in its early stages, investing in a pre-IPO like Ethio Telecom comes with unique risks. The Ethiopian Securities Exchange is a new frontier, and market conditions may be volatile as the exchange matures. Regulatory changes, political shifts, and economic fluctuations could all impact Ethio Telecom’s performance and the overall stock market in Ethiopia.

Is Ethio Telecom a Good Deal?

At ETB 300 per share, Ethio Telecom offers an intriguing opportunity. The company appears to be slightly undervalued compared to its African peers, which could signal that there’s potential for future growth. If Ethio Telecom continues to perform well, early investors could see significant returns once the company goes public.

However, as with any pre-IPO investment, there are risks to consider. The limited liquidity, potential information gaps, and the uncertainties surrounding the Ethiopian stock market are all important factors to weigh before making a decision.

In the end, whether Ethio Telecom is a good deal depends on your risk tolerance and investment horizon. If you’re comfortable with holding onto your shares for the long term and navigating the uncertainties of an emerging market, this could be an opportunity worth considering. But if you’re looking for a quick profit or prefer safer, more liquid investments, it might be wise to approach with caution.

So, the big question remains: are you ready to take the plunge and invest in Ethio Telecom at ETB 300 per share, or will you wait and see how the market plays out? Only you can decide if this ride is worth the price.

Dr. Abush Ayalew is a passionate advocate for financial literacy and empowerment. He holds an MBA in Finance from Lincon University (Gold Medalist) and has years of experience in the global stock market. He is the founder of Adwa Transformation Center, an online platform dedicated to providing accessible and practical financial education. Dr. Abush is also the author of several books on finance and investing. He believes that everyone has the potential to achieve financial freedom through knowledge and strategic action.

Ready to deepen your understanding of investment strategies and market dynamics? Enroll in our comprehensive stock market courses at Adwa Transformation Center and gain the knowledge and skills to navigate the complexities of the financial world with confidence! Visit our website: https://www.adwatransformation.com.