Valuing Stock (Share)

After you have spent hundreds of hours filtering hundreds of companies, you uncovered a great company with a competent and ethical management team couple with deep and wide economic moats. Next, and also the most important step, is to put a valuation on the company and its stock.

Putting too high value on a stock will result in you paying too much for the stock. On the other than, putting too low value on a stock will result in you missing out on buying great stocks because they do not meet your strict valuation. Therefore, it is critical for you to value the stock as close to its intrinsic value as possible. Between valuing too high and too low, it is better to be strict and value lower. Sure you may miss out on great opportunities, but you avoid buying lemons that could burn your money.

There are 2 approaches to value a company or stock. Relying on the historical data published in the financial statements, you can calculate and use the P/S (Price to Sales) ratio, P/E (Price to Earnings) ratio, Earnings Yield and the P/B (Price to Book Value) ratio.

The other approach is to rely on the estimated future cash flows of the company. It's called the discounted cash flows method.

P/S (Price to Sales) ratio

The P/S ratio is the most basic ratio. It is calculated by using the market price of the stock divided by sales per share.

The above formula can also be expressed as follow.

The benefit of using the P/S ratio is that the sales figure is cleaner than the earnings figure. Usually the accounting tricks that are used to boost earnings do not affect sales because sales manipulation is easy to detect.

Sales is also not as volatile as earnings because it is not affected by one time charges. If a company makes one time charges frequently over several years, this makes it difficult to use earnings to calculate and compare P/E ratios over several years. In this case, comparing the P/S ratios over several years will be more meaningful.

There is one flaw in comparing the P/S ratios. It doesn't take into account the profitability of the company. If a company's profitability has decreased, but sales remains the same, then logically the net earnings will also decrease. So, the stock price should decrease as well. But when you use P/S ratios, you will value the price the same as last year because the sales level remains the same.

Different industries have different risks and you should only compare P/S ratios with companies in the same industry.

P/E (Price to Earnings) ratio

P/E ratio is the most popular valuation ratio because it is easy to calculate. The EPS can be obtained from just about any financial data source.

Usually you can find the EPS in the Income Statement.

The easiest way to use the P/E ratio is to compare it to the industry average or the industry benchmark. You could also use it to compare with P/E ratios of other companies within the same industry.

A stock that is trading at a lower P/E than other companies in the same industry could be a value buy. However, bear in mind that companies in the same industry may have different capital structures, risks, growth rates and economic moats. All these will affect the market price of the stock. All else equal, it makes sense to pay more for a share if the company has higher growth rates, has less debt and has lower capital reinvestment needs.

If you find a solid company with stable growth rates as previous years and the company hasn't changed its business prospects much, but it's trading at a lower P/E than its long-term average, then this stock could be trading at below value and you may want to investigate further if it truly is a bargain.

When using P/E, you need to be careful with one time charges or gains. If a company sells part of its business and made a gain, then this will inflate the earnings. This in turn will lower the P/E. You will need to adjust the earnings figure by removing the one time charges.

P/B (Price to Book) ratio

The P/B ratio compares the market value with the book value. This approach is more relevant to valuing stocks where companies have huge tangible assets in the balance sheet. After all, these assets are used in producing income for the company. These assets will also fetch some value in liquidation.

P/B ratio is a very powerful tool to find undervalued financial firms. This is because most of the assets in the balance sheet such as investments are revalued every quarter and the figures in the balance sheet value is reasonably current.

For companies with intangible assets such as patents and brands as well as service firms, the P/B ratio will yield little meaning. This is because these companies rely mostly on processes, economic moats and human capital and knowledge to generate income.

In summary, these ratios provide you with some ways to estimate the value of a stock. There are many non-financial factors to consider when reading these ratios. You may also want to factor in a safety margin when valuing your stock.

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