Valuation, it is often said, is more of an art than an exact science.
I tend to agree with the above statement, as valuation, in itself, only captures a snapshot of the company at a specific point in time.
It may also tell you a lot about the company’s past, but does not give you any indication of what its future potential may be.
Hence, when looking at different valuation metrics, you have to understand their overall context and also be aware of their limitations.
That said, valuations can be useful to get a sense of whether shares are cheap or expensive.
As we approach the stock market to look for great companies to buy, valuation provides us with a reference point and guides both our investment decisions and sizing.
Simply put, if a company is trading at lofty valuations, we may consider avoiding it or sizing it smaller within our portfolio to minimize risks.
Here are three methods you can use to gain some perspective of whether shares are fairly priced, or not.
The price to earnings ratio (PER)
The first method involves the profitability of the business.
The price to earnings ratio, also known as the PER, is computed by taking the share price and dividing it by the full fiscal year earnings per share (EPS) of the company.
A simple example would be a company with an EPS of S$0.10 and a share price of S$1.00. Its PER would thus be 10 times (i.e. S$1.00 divided by S$0.10).
PER are normally compared across a range of companies within an industry.
For instance, you could compute the PER of five electronics companies to assess which is the cheapest of the lot.
However, do note the inherent limitations of using the PER method.
First off, earnings could be affected by a myriad of factors such as write-offs, impairments or one-time adverse events such as the current pandemic.
These adjustments may depress earnings significantly in the short-term, giving the impression that the PER is much higher than it should be.
Another problem is that earnings can be manipulated by management to some extent.
During bad years, a decision can be made to write-off inventory, debtors or other types of assets, in a process known as “kitchen-sinking”.
In contrast, good years may see the practice of management deferring capital expenditure so as to avoid charging depreciation to the books, thereby artificially inflating net profit.
Such practices, while not illegal, do end up distorting the EPS figure and may not paint an accurate picture of a company’s financial health.
Price to free cash flow (PFCF)
A second, more stringent method is to value a company based on its free cash flows.
Some companies that are continually growing and building up their asset base may incur high amounts of depreciation, thereby depressing net profit.
Depreciation is a non-cash expense that has no impact on the cash flowing through a business.
By using the cash flow statement as the basis for valuing a company, investors avoid the problem of adjustments and non-cash items as stated above.
Price to free cash flow, or PFCF, is computed by taking the share price and dividing it by the free cash flow (FCF) per share.
FCF, in turn, is the deduction of capital expenditure incurred from the operating cash flows of the business.
This method is more rigorous as it relies on what is essentially the lifeblood of the business – cash flow.
Price to book value (PB)
A third method that can be used to value a company is the price to book ratio, or PB.
This method is used mainly for companies that have large amounts of physical assets such as properties, or heavy plant and equipment.
The assumption here is that these assets have a carrying value that can be realised in a sale, and buying a business at a discount to this value (i.e. a PB below one) then provides the investor an opportunity to realise this value.
The book value of the business is computed as the total assets minus total liabilities, and is also known as the equity of the business.
The PB is computed by taking the share price and dividing it by the book value per share.
In general, a PB below one suggests that the stock market may be undervaluing the assets within the business.
However, a note of caution should be sounded.
Book value may not always be a reliable measure of the market value of the business’ assets, as it relates to assets that were procured during different historical periods.
Hence, there is a possibility that book value may be adjusted downwards if the assets were revalued according to their current market values.
The PB may then not be as low as it used to be should such an event occur.
Want to know what stocks we like for our portfolio? See for yourself now. Simply CLICK HERE to scoop up a FREE copy of our special report. As a bonus, we also highlight 6 blue chips stocks trading at a 10-year low. But you will want to hurry – this free report is available for a brief time only.
Disclaimer: Royston Yang does not own shares in any of the companies mentioned.