In this article, we will answer a Foolish question asked by one of our readers. He asked the following (edited slightly): “How do we go about determining the value of a stock and that it is not overvalued now?”
There are a number of ways to value a company. Let’s take a look at three of them (in no particular order).
The first method would be the price-to-earnings (PE) ratio. The PE ratio is obtained by dividing the current stock price by the earnings per share (EPS) of the company. For example, the EPS of Singapore Exchange Limited (SGX: S68) for Financial Year 2013 was $0.314. The share price, at the time of writing, is $7.63. Therefore, $7.63 divided by $0.314 gives a PE ratio of 24.3. The PE ratio can be used for service and manufacturing companies. To determine if the company is overvalued or undervalued, the PE ratio can be compared across the industry. If the PE ratio of Breadtalk (SGX: 5DA) is higher than its peers in the Food & Beverage industry for instance, it may be deemed to be overvalued and vice versa.
The next method is the price-to-book (PB) ratio It is also sometimes called the price-to-net-asset-value (P/NAV) ratio. The book value and the net asset value (NAV) mean the same thing. The book value of a company is the total assets minus total liabilities. The PB ratio is obtained by dividing the current stock price by the book value of the company. For example, the book value of City Developments Limited (SGX: C09) is $8.30, as of 30th June 2013. The share price, at the time of writing, is $10.47. Therefore, $10.47 divided by $8.30 would give a PB ratio of 1.26. The PB ratio is generally used for companies that are asset-heavy, like property companies and real estate investment trusts (REITs), and banks. Generally, a PB of less than one means that the company is undervalued and anything above one may mean the company is overvalued.
Another method is the price-to-sales (PS) ratio. This ratio is usually used for companies that are not making profits but are expected to turnaround soon. The PS ratio is obtained by dividing the current stock price by the revenue (or sales) per share of the company. Another way is to divide the current market capitalization by the total revenue of the company for the year. Revenue and sales mean the same thing. For example, Grand Banks Yachts Limited (SGX: G50) has had negative earnings since the sub-prime crisis as it was impacted heavily during the downturn. To calculate its PS ratio, take the current market capitalization of $39.8 million divided by the total revenue of $35.3 million to yield 1.13. The PS ratio has to be compared with its peers to determine if it is undervalued or overvalued.
Other valuation methods include PEG (PE/annual EPS growth rate) ratio, discounted cash flow (DCF), discounted dividend model (DDM), enterprise value multiples and other price multiples like price-to-cash flow ratio. We have to bear in mind that the valuation methods and the value obtained are not cast-in-stone. These numbers and ratios can be drastically altered if our assumptions that go into them are changed and it’s something investors have to take note of. For example, in a comparison across industry-peers when using the PE or PS ratios, the implicit assumption is that its peers are valued correctly as well.
This means that valuations are fluid and they change as the fundamentals of the company change. Warren Buffett said that he rather be approximately right than precisely wrong when it comes to valuation. We do not need to get a precise figure down to the eighth decimal point when it comes to valuation. A ballpark figure is good enough.
Publish date: 03/10/13