Judging a stock’s value

A look at valuation metrics.

The thought of buying stocks may seem daunting, especially if you have read through textbooks that say that stocks should be bought when they trade below their intrinsic value. But how can you arrive at this intrinsic value? Well, that’s where valuation metrics come in. Read on to learn about some of these metrics and the stories they tell.

Price-earnings (PE) ratio: A key value indicator, the PE ratio measures the price that the stock market is willing to pay for every rupee of net profits (earnings) generated by the company per share.

When the ratio is on the high side, it means that investors are willing to pay more for that stock, because they expect its earnings to grow at a faster rate than its peers. Normally, a stock with a low PE ratio is cheap, if that isn’t reflecting high growth expectations. For example, a good part of last year saw real estate stocks command quite a premium over other sectors.

Price-to-book value: This is another ratio used to value stocks. It is arrived at by dividing the market price per share by the book value of each share. But what, in the first place, is book value? In essence, it is the assets of the company (such as land, plant and machinery etc) after deducting liabilities. In other words, it shows how much would be left for shareholders if the company folded immediately.

Dividend yield: This ratio is a measure of the dividend paid out by the company relative to its share price. If, as an investor, you give higher weightage to earning steady cash flows rather than capital gains, stocks with high dividend yields may be what you should look at.

Market capitalization: Simply put the price per share multiplied by the total number of outstanding shares. The market capitalization is often used to gauge what the market is willing to pay for an entire company. Apart from being used in takeover situations, ratios such as market cap-to-sales are used to value companies, especially so when they are yet to generate book profits.

A more evolved metric is the enterprise value (EV) or the sum of the market cap and debt of the company reduced by its cash balance. The EV reflects the market value of the company or the amount you might have to pay if you bought out the company. EV is used in relation to parameters such as sales. This metric is often used when analyzing cement companies.

A stock is said to be overvalued, if it enjoys a higher PE ratio or a higher price-to-book value relative to its peers in the sector or its growth prospects. Undervalued stocks are those that trade at low ratios, but have strong prospects which have been overlooked by investors.

What to apply

Ratios such as price-to-earnings or price-to-book can be calculated on a historic basis (past earnings) or expected future earnings (estimated). However, price and earnings ratios may be used only where the company has been around for some time and has logged revenues and profits.

For loss-making companies, ratios based on market capitalization to sales or enterprise value may provide a better assessment of their businesses’ worth. While the ratios discussed above are universally used, some may be more suitable to a specific sector than others.

For example, when looking at banking stocks, book value shows a better picture of assets and liabilities (since they indicate future earning capacity) than a simple earnings ratio.

Source: Hindu