Chapter 2: Common Stock Valuation Terms – Part 2

We have already covered market capitalization and EPS. Let’s jump right to the next one:

Say you want to compare the stocks of two companies – Company A and Company B who are a part of the automobile industry, to invest in.

The per share price of Company A is Rs. 100. The price per share of Company B is Rs. 150. But, this does not mean Company A is a better investment just because it is cheaper.

A low share price does not mean the company is undervalued. It’s only undervalued when the price of the share is low, relative to the amount of money the company is making.

1. P/E (Price to earnings) ratio>

To evaluate Company A and Company B, you need a common measurement.

This standard measurement is the P/E Ratio. Price to Earnings ratio is one of the most important parameters for stock valuation. P/E ratio measures the price of a stock relative to its annual earnings (EPS). It is calculated as follows:

P/E ratio = Market price / EPS

Now, for the same companies, let’s evaluate the P/E Ratio –

 

Company A

Company B

EPS (Rs.)

10

5

Market price (Rs.)

100

150

P/E Ratio

10

30

 So, from the above table, we understand that if you purchase the shares of Company A, you will have to pay ten times the earning. But for Company B, you will need to pay 30 times the earning! This the stocks of Company A seems undervalued and a better investment choice between the two.

The lower the P/E Ratio, the better it is for their potential investors.  And companies with high P/E ratios are considered as suitable investments if they have justifiable high growth estimates. 

There are two types of P/E ratio - Forward P/E Ratio and Trailing P/E Ratio.

Let’s understand them both.

  • Forward P/E Ratio is based on the future earnings of a company. It is determined by dividing the prices of stock by the expected future EPS. In most cases, analysts use the forward P/E to get a better and more realistic future-price estimation.
  • Trailing P/E Ratio is based on total past 12 months’ earnings of a company. It is measured by dividing the prices of the stock by the past year’s EPS.

But the stock market is always forward looking, so the P/E ratio alone does not help an investor. It’s essential to also estimate the future growth prospects of the company. 

To understand how to include future prospects, let’s look at the next evaluating ratio - Price earnings to growth ratio (PEG). 

2. PEG (Price Earnings to Growth) ratio

The PEG ratio not only considers the P/E ratio but also studies future earnings growth estimates of a company.

If we look at the P/E ratio in isolation, a higher P/E ratio may seem expensive, but if those stocks also have a higher growth estimate, then higher P/E looks justified.

You can calculate it as follows:

PEG Ratio = P/E ratio / Earnings growth rate

Let’s look at the automobile companies once again –

 

Company A

Company B

EPS (Rs.)

10

5

Market price (Rs.)

100

150

P/E Ratio

10

30

Earnings growth rate

5%

30%

PEG ratio

2

1

If a stock has a high P/E ratio and a higher growth rate, then the PEG ratio would be lower. Stocks having a low PEG ratio, less than one, are considered suitable for buying. But a PEG ratio of more than one may be regarded as an expensive valuation.

So, if we consider this, which one would be an ideal investment choice?

That’s right. Company B.

Even though its market price is high and the P/E ratio is also high.

But what if companies have huge liabilities? Wouldn’t that be a cause of concern to investors?

Yes, of course, it would. To evaluate this, let’s look at other essential evaluating parameters when liabilities are a concern.

3. Enterprise Value multiple or EV/EBITDA

The valuation of a company through P/E multiple has one major drawback. It only focuses on the capital structure's equity portion and ignores the debt component. However, a company with a higher debt trades at a lower P/E multiple in the market. So a better way to evaluate the companies with debt on their book is the EV/EBITDA approach.

EV/EBITDA = Enterprise value / Earnings before interest, tax, depreciation and amortization

Where Enterprise value (EV) = Market value of equity + Market value of debt – Cash on hand

In simple terms, enterprise value is the price you pay to acquire the company. When you acquire the company, you pay the amount equivalent to the company's equity, absorb the company's debt, and take the credit entry of the cash balance.

So, what does EV/EBITDA indicates?

It indicates the time to recover the acquisition cost via EBITDA. For example, if a company has an EV/EBITDA of 10, it takes ten years to cover the acquisition cost as per the current EBITDA. As a thumb rule, a lower EV/EBITDA multiple is better, but debt should not have a high cost. However, you can't make the investment decision based on a single parameter and other factors like growth, industry averages, etc., need to be considered.

4. Book value

The book value of a stock refers to the net worth of the stock. It is a critical parameter to evaluate the stock of companies that have a huge asset and liabilities base. It is derived by dividing the net worth of the company by the total number of outstanding shares.

Book Value = (Total Assets – Total Liabilities) / Total number of outstanding shares

Book value can also be defined as the amount a shareholder receives if the company is liquidated.

5.  P/BV (price to book value) ratio

For investors, the P/BV ratio is a vital valuation parameter that helps when making investment decisions.

You can calculate it as follows:

P/BV = Market price / Book value

If P/BV is less than 1, it may seem that it is a good price to invest. But you need to be cautious about asset and liability quality and the values assigned to them on the company books.

Most analysts discount the company's net worth if the quality of assets is not up to the mark. And that’s the reason why it’s important to get a detailed analysis of book value through quality research reports instead of mere numbers provided by the management on the balance sheet.

But as an investor, if there is one ratio you need to know about, it would be Return of Equity.

Benjamin Graham, known as the father of value investing, pointed out in his book – 'The Intelligent Investor’ that one should not just consider stocks as a number on the stock exchange but must thoroughly analyse a company and the soundness of its underlying businesses.

As an investor, how can you do that?

This brings us to one of the most essential valuation parameters -

6. RoE (Return on Equity)

RoE is a crucial parameter that highlights the efficiency of a company in producing profit for its shareholders.

You can calculate RoE as follows:

Return on Equity (RoE) = Net Profit / Equity Capital

Let’s look at our automobile companies once again:

 

Company A

Company B

Annual Profit (Rs.)

10 crore

10 crore

Equity Capital (Rs.)

50 crore

100 crore

RoE

20%

10%

Here, both companies were able to earn the same profit for the year.

But, if we consider the RoE ratio, Company A becomes a better investment opportunity than Company B. That’s because Company A has the potential to provide superior returns on its equity capital. It is also an indication of better utilization of company assets by Company A’s management to generate more profits for its shareholders.

Did you know? 

Return on Equity ratio is the American billionaire investor Warren Buffet’s favourite equity valuation ratio. He was quoted saying, “Focus on Returns Per Equity and not Earnings per share.”

 

Economic Moat

The one thing that every business has is competition. And while there is no formula to help investors calculate this in relation to a business, Economic moat is that one factor, which reflects a company’s ability to maintain its sustainable competitive advantage over competitors in the long run to protect its profits. It means a company with a moat is generally sought-after by investors.

But how can a company create an Economic Moat?

There are in fact four main ways to create an economic moat.

  • Production advantages – This is when the company is able to provide products or services cheaper than its competitors.
  • High switching cost – Switching costs can be monetary, psychological, time-based or effort-based that the consumer has to pay if they switch to another brand or product.
  • Network effect This happens when the value of a product or service increases as more and more people start using those goods or services. 
  • Brand value – This is when the company is able to generate more revenue or charge a premium rate due to its brand recognition, patent, government licenses, etc.

So, in financial terms, a business with an economic moat has high free-cash flows, low cost of capital and a positive return on invested capital.

Also Read: Do you have moat in your portfolio: Understanding Economic Moat

Did you know? 

Economic Moat was popularized by famous investor, Warren Buffet. He believed companies with strong economic moats are more likely to be successful in the long-term as they can maintain their competitive edge.

Summary

  • P/E ratio measures the price of a stock relative to its annual earnings (EPS).
  • EV/EBITDA indicates the time to recover the acquisition cost via EBITDA
  • RoE is a crucial parameter that highlights the efficiency of a company in utilising capital.
  • An Economic moat is one factor that reflects a company's ability to maintain its sustainable competitive advantage over competitors in the long run to protect its profits.

Let’s head on to the next chapter, which explains the different types of stock investing.

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