As an investor, one useful skill is to identify companies that are undervalued before the rest of the market discovers their attractions. But while the market uses a number of commonly accepted techniques, valuing a company remains highly subjective. Often it comes down to a matter of opinion. Nevertheless, there are a number of ways to assess the value of a company, including:
What is the Price/Earnings ratio?
The P/E ratio shows the number of years' earnings per share (EPS) contained in the current share price. In other words, it shows the number of years at current earnings needed to cover the current share price and is one major signpost every investor should be aware of.
The price/earnings ratio (P/E ratio) is commonly used to assess the level of confidence investors have in a company. It represents the market's view of a company's growth potential. By comparing P/E ratios between companies and across business sectors, investors hope to identify undervalued stocks.
A high price/earnings ratio indicates that investors have a high level of confidence in a company's future prospects. But while a company with a high P/E ratio relative to its sector may have exciting growth prospects, it might equally be considered to be overvalued depending on prevailing market circumstances. So while P/E can be a useful measure of a company's value, it should also be treated with caution.
P/E ratios vary dramatically between sectors. For example, in the new high-tech economy, we have become accustomed to huge valuations for companies that are making enormous losses. Some broking firms have even begun to calculate negative P/E ratios for the purpose of comparing these companies. Other brokers simply will not quote a P/E ratio for a loss-maker.
While traditionally companies were valued using P/E multiples, it is now becoming commonplace for the market to value companies on the basis of projected turnover even though they may be making major losses. Meanwhile, high-tech companies that are actually making money carry extraordinarily high P/E multiples.
How is the P/E ratio calculated?
The P/E ratio is arrived at by dividing the stock price by post-tax earnings per share (EPS).
Earnings per share is calculated by dividing a company's 12 month earnings by the number of outstanding shares.
Like most performance indicators, the P/E ratio works best if it is monitored over a length of time; that way it is possible to discern a trend rather than relying on a snapshot of a given moment.
The PEG ratio
In some brokers' research you may come across the PEG ratio. The PEG (price earnings growth) measures the relationship between a stock's P/E ratio and its growth rate.
The higher a company's expected growth rate is, the higher its P/E ratio.
To calculate PEG, simply divide the P/E ratio by the stock's growth rate.
A stock is fairly valued if the PEG ratio is equal to 1.
A stock is undervalued if the PEG is less than 1. Action: buy the stock.
A stock is overvalued if the PEG ratio is greater than 1. Action: consider selling the stock.
At the simplest level, a company is worth the value of its assets minus its liabilities - its "book value".
Book value is the amount of money that would be available to shareholders if the company's assets (excluding intangibles such as copyright and patents) were sold at their balance sheet value and all liabilities were paid. For example, if assets equal £50m, while liabilities are £30m, then the company's book value is £20m.
How is book value calculated?
Book value is often expressed in terms of book value per share (book value divided by the number of outstanding shares). The market price per share is then compared to the book value per share. This is known as the price-to-book value ratio. It is calculated as:
Price-to-Book Value Ratio = Market Price Per Share ÷ Book Value Per Share
Limitations of Book Value
A major drawback with book value is that it is difficult to value assets accurately. There are a variety of legitimate accounting techniques for measuring tangible assets, all of which arrive at different valuations. It may be unrealistic to assume that the value of a tangible company asset on the balance sheet equals the value it would fetch if it were to be sold off.
Be careful to distinguish between book value and realisable value.
For example, a company building may have depreciated to zero over time, yet may have a market value of millions of pounds. Similarly, a company operating in a very fast-moving industry may be showing a high-tech computer in its books at a significant value. That computer might, however, fetch very little in the market were it to be sold immediately.
It is even more difficult to value intangible assets such as patents and brands. This problem is compounded by the fact that in recent times a far higher value has been placed on intangible assets than in the past.
Many analysts would contend that for the purposes of company valuation, the only value that matters is the value the stock market puts on a company. That value is known as market capitalisation and is simply the number of shares in issue multiplied by the market price per share.
Of course if not all of company shares are made available to the public (free float or free capital) then you must adjust the market capitalisation figure upward to take account of this. So, for example, if a company has issued 100 million shares trading at £7.00 its market capitalisation will be £700 million. But if these shares issued to the public comprise just half its total shares then the true market capitalisation is 1.4 billion pounds.
Naturally, because the stock price is constantly fluctuating, the market capitalisation fluctuates also.
Valuing established companies is difficult enough, but valuing start-up companies is trickier.
Typically, most start-ups make losses for several years, yet many technology start-ups, for example, can have huge valuations.
In the absence of profits, many analysts instead focus on sales growth as a measure of the future growth potential of such companies, and this is reflected in the sales-to-stock price ratio.