How to do a valuation on a company’s stock?

How to do a valuation on a company’s stock?

All investors hope to peer into a crystal ball to know whether a company’s stock is worth investing in based on the current market price. Unfortunately, there is no crystal ball for market performance.

One of the basic valuation metrics of a stock is Price to Earnings Ratio (PE Ratio), which was made popular by the late Benjamin Graham, also known as the Father of Value Investing.

Basically, the PE Ratio is used to value a stock, whether it is undervalued or overvalued when compared to the same industry as a benchmark.

Let’s look at the formula of the PE Ratio:

PE Ratio = (Market Price)/(Earnings per Share)

There are two different perspectives to look at this valuation metric.

First Perspective: Number of years to recover one’s investment principal

In one way, the PE Ratio can be used as a reference to how many years it would take to recover one’s investment principal from earnings a company generates based on a full year or latest four quarters’ earnings.

For example, let’s say the market price of RHBCap is RM8.02, and its EPS for the Financial Year 2013 is 72.9sen. The PE Ratio is 11 times.

PE Ratio = 8.02/0.729 = 11x

Based on this example, for every share purchased, it would take you 11 years of cumulative earnings to equate to the current stock price.

From this perspective, the lower the PE Ratio valuation, the shorter period of time for an investor to recover his/her investment principal, and thus the investment risk is lesser.

However, do consider the second perspective of this valuation metric.

Second Perspective: Reflecting the prospects of a company’s future earnings

In another way, the PE Ratio reflects the confidence level of the investors towards the company’s future earnings prospects.

From the second perspective, this financial ratio gives investors an idea of what the market is willing to pay. The higher the PE Ratio indicates the market has higher hope for the company’s future and thus bids up the price.

The growth in earnings will bring the PE Ratio back down to a lower level, and thus an investor will feel comfortable buying the stock even if it has a high PE Ratio.

Conversely, a low PE Ratio potentially shows the investors are lacking confidence and/or have a negative outlook about the company. Decrease in earnings will push the PE Ratio to a higher level.

Case Study

Let’s look at the two different cases to explain the PE Ratio:

Example 1: Company A, Company B and Company C are operating the same type of business in the oil and gas industry. Their earnings, stock price and PE Ratio are summarised as follows:

EPS (RM)

Stock Price (RM)

PE Ratio

Company A

0.25

3.00

12

Company B

0.30

4.20

14

Company C

0.20

3.20

16

INDUSTRY AVERAGE

14

Assuming there are only three oil and gas companies listed in the stock exchange and having the same earnings outlook. Based on the data above, the average PE Ratio for the industry is 14 times.

For Company A, it is considered undervalued, as the ratio is lower than the industry average.

For Company B, it is considered fair value, as the ratio is par with the industry average.

For Company C, it is considered overvalued, as the ratio is higher than the industry average.

Based on this example, Company A is worth to invest in and the investment risk is relatively lesser compared to Company B and Company C.

Example 2: Company Y and Company Z are operating the same type of business in the glove industry. Both companies are having same earnings but different stock prices, as summarised below:

EPS (RM)

Stock Price (RM)

PE Ratio

Company Y

0.30

4.50

15

Company Z

0.30

5.10

17 

Let’s assume Company Y’s production capacity is close to the maximum level and is unable to get more orders from clients, and Company Z is aggressively expanding its production capacity to cater to more demand from its clients.

Due to the production restriction, Company Y is forecasting its earnings growth at 5% for the next 12 months. However, Company Z is forecasting to have double digit growth rate at 20%.

Based on the earnings growth rate, the EPS for Company Y is estimated to be at 31.5sen and Company Z is 36sen.

Applying the current stock price for the future earnings, the PE Ratio will then be as follows:

Estimate EPS (RM)

Stock Price (RM)

 Forward PE Ratio

Company Y

0.315

4.50

14.29

Company Z

0.36

5.10

14.17

The Forward PE Ratio shows that Company Z’s valuation is more attractive than Company Y.

Conclusion

In short, the PE Ratio is useless on its own and the ratio does not tell you anything, unless you compare it to other companies in the same industry.

Assuming all other factors are equal, including the future earnings outlook of companies of the same industry, the company with lower PE Ratio will have more investment value.

However, one of the limitations about the PE Ratio is, if a company is making losses, this financial ratio is not applicable. In the next article, we will look at the alternative valuation method.