9.19 Other stock valuation methods

Stock Valuation

Though we were discussing throughout this chapter about the how to value a stock- there are other methods also worth mentioning here. Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks. So let us discuss both types of valuations. First, the fundamental valuation. This is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio (discussed earlier). This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices. The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and is often drives the short-term stock market trends. In short, there are many different ways to value stocks. It may be apt to list few of them here. The key is to take each approach into account while formulating an overall opinion of the stock. Look at each valuation technique and ask yourself why the stock is valued this way. If it is lower or higher than other similar stocks, then try to determine why. And remember, a great company may not be always a great investment. Here are the basic valuation techniques:

Earnings per Share (EPS).

We have discussed the EPS earlier in the chapter

Price to Earnings (P/E).

We have also discussed PE ratio in detail. For example, if the stock is trading at Rs.100 and the EPS is Rs 5, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios. Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. We can also look at the historical trends of the P/E by viewing a chart of its historical P/E over the last several years (we can find it on most finance sites like Yahoo Finance or rediff finance). Specifically we need to find out what range the P/E has traded in, so that we can decide how the current P/E is pitched against historical average.

Forward P/Es are probably the single most important valuation method because they reflect the future growth of the company into the figure. And remember, all stocks are priced based on their future earnings, not on their past earnings. However, past earnings are sometimes a good indicator for future earnings. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar of fiscal year or two.(in our intrinsic value calculation it is shown in detail)

Growth Rate.

Valuations rely very heavily on the expected growth rate of a company. To begin with we can look at the historical growth rate of both sales and income to get a feeling for what type of future growth that we can expect. However, remember, companies are constantly changing. So to calculate our future growth rate, we need to do our own investment research. And for any valuation technique, we really want to look at a range of forecast values. For example, if the company we are valuing has been growing earnings between 5 and 10% each year for the last 5 years but suddenly thinks it will grow 15 - 20% this year, we may want to be a little more conservative than the company and use a growth rate of 10 - 15%. To take another example, would be for a company that has been going through restructuring. They may have been growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore you would want to forecast earnings growth closer to the 0 - 5% rate than the 15 - 20%. So the important point to be noted is that we may also use our gut feeling to make a forecast. So get as close as to the company before you make this forecast.

PEG Ratio

Another important valuation technique and became more popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio (or in other words Price Earnings to Growth ratio) divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it’s traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100%, the stock becomes more and more overvalued, and as the PEG ratio falls below 100%, the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the long-term growth rate of a company’s earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process.

Let us discuss an example, to quote how to use the PEG ratio. Suppose that we are comparing two stocks for a buy. Stock XYZ is trading at a forward P/E of 15 and expected to grow at 20%. Stock ABC is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock XYZ is 75% (15/20) and for Stock ABC is 120% (30/25). According to the PEG ratio, Stock XYZ is a better purchase because it has a lower PEG ratio, or in other words, you can purchase it’s future earnings growth for a lower relative price than that of Stock ABC.

Return on Invested Capital (ROIC)

This valuation technique measures how much money the company makes each year per rupee of invested capital. Invested Capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent and we should look for a percent that approximates the level of growth that we expect. In it’s simplest definition, this ratio measures the investment return that management is able to get for its capital. The higher the number, the better the return. To compute the ratio, take the pro forma net income and divide it by the invested capital. Invested capital can be estimated by adding together the stockholders equity, the total long and short term debt and accounts payable, and then subtracting accounts receivable and cash (all of these numbers can be found on the company’s latest quarterly balance sheet). This ratio is much more useful when we compare it to other companies that you are valuing.

Return on Assets (ROA)

Similar to ROIC, ROA, expressed as a percent, measures the company’s ability to make money from its assets. To measure the ROA, take the proforma net income divided by the total assets. However, because of very common irregularities in balance sheets (due to things like Goodwill, write-offs, discontinuations, etc.) this ratio is not always a good indicator of the company’s potential. If the ratio is higher or lower than we expected, be sure to look closely at the assets to see what could be over or understating the figure.

Price to Sales (P/S)

This figure is useful because it compares the current stock price to the annual sales. In other words, it tells us how much the stock costs per rupee of sales earned. To compute it, take the current stock price divided by the annual sales per share. The annual sales per share should be calculated by taking the net sales for the last four quarters divided by the fully diluted shares outstanding (both of these figures can be found by looking at the press releases or quarterly reports). The price to sales ratio is useful, but it does not take into account any debt the company has. For example, if a company is heavily financed by debt instead of equity, then the sales per share will seem high (the P/S will be lower). All things equal, a lower P/S ratio is better. However, this ratio is best looked at when comparing more than one company.

Market Cap

Market Cap, which is short for Market Capitalization, is the value of all of the company’s stock. To measure it, multiply the current stock price by the shares outstanding. Remember, the market cap is only the value of the stock. To get a more complete picture, you’ll want to look at the Enterprise Value.

Enterprise Value (EV)

Enterprise Value is equal to the total value of the company, as it is trading for on the stock market. To compute it, add the market cap and the total net debt of the company.

The total net debt is = total long and short term debt +accounts payable- minus accounts receivable- cash.

The Enterprise Value is the best approximation of what a company is worth at any point in time because it takes into account the actual stock price instead of balance sheet prices. Enterprise Value fluctuates rapidly based on stock price changes.

Enterprise Value to Sales

This ratio measures the total company value as compared to its annual sales. A high ratio means that the company’s value is much more than its sales. To compute it, divide the EV by the net sales for the last four quarters. This ratio is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times. For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company’s cash flow and is used for valuing both public and private companies. To compute EBITDA, use a company’s income statement, take the net income and then add back interest, taxes, depreciation, amortization and any other non-cash or one-time charges. This leaves us with a number that approximates how much cash the company is producing. EBITDA is a very popular figure because it can easily be compared across companies, even if all of the companies are not profitable.

EV to EBITDA

This is perhaps one of the best measurements of whether or not a company is cheap or expensive. To compute, divide the EV by EBITDA (discussed above). The higher the number, the more expensive the company is. However, remember that more expensive companies are often valued higher because they are growing faster or because they are a higher quality company. With that said, the best way to use EV/EBITDA is to compare it to that of other similar companies.