With so many stocks to choose from, it can be a daunting prospect investing in shares. Many companies engage in similar operations, making it difficult to prioritise one over the others.
For some investors, that is why stock valuations play a role, however, there is often great difficulty arriving at an agreeable conclusion. As you may have come to realise by now, share valuations are based on a wide variety of factors and everyone in the share market has an opinion.
Consider the major iron ore miners – Rio Tinto (ASX: RIO), BHP Billiton (ASX: BHP) and Fortescue Metals Group (ASX: FMG). Sometimes you may hear commentary where one of these stocks is considered better ‘value’ than the others. How does one arrive at this conclusion though?
There are a variety of ratios used to compare and value similar stocks. In fact, you will find many of them in your SelfWealth trading account as part of our stock analysis tool. Before you begin investing in shares, even a basic grasp of these simple valuation ratios could prove helpful.
Why is it important to value shares?
Although it may be reassuring to think that your instinct is always right, the stock market usually requires more rigour and due diligence than one’s gut feeling.
Whereas traders embrace technical analysis, using charts and algorithms to identify patterns that offer potential share trading opportunities, investors often reach for fundamental analysis. This includes two types of stock valuation methods. One is intrinsic share valuation, where inherent financial information like discounted cash flow is considered.
The other method is relative valuation, which involves peer comparison. By analysing two comparable companies, you may identify valuation discrepancies. For example, you might be about to invest in a stock that is ‘overvalued’ relative to its peers. Alternatively, you might find an ‘undervalued’ stock offering upside potential, or take profits on a stock that has run up too quickly.
Three simple valuation ratios
The most well-known valuation ratio, the Price-to-Earnings ratio (P/E) is a measure of the price of a stock compared with its earnings. Another way to think of it is the price the market would pay for every $1 the company generates in profit, with the view that investing in shares is based on future growth expectations from today’s earnings. Historically, the ASX has traded with a P/E of about 15.
If you wish to calculate the P/E ratio, you need to establish the company’s earnings per share (EPS). While you can source this from your SelfWealth trading account, you can also find EPS in the company’s latest financial report. These numbers are likely to be delayed, in which case you can always adopt a forward-EPS based on your expectations for earnings in the year ahead.
A common train of thought is that a stock with a lower P/E ratio is ‘better’ value than its peers. Of course, this is a rather simplistic if not misguided assumption.
P/E ratios vary considerably from one sector to the next. Tech shares tend to trade at a significantly higher P/E ratio than financial stocks due to their high-growth outlook for future earnings. Even within an industry, some stocks command a higher P/E ratio due to specific growth prospects. Alternatively, some shares may command a lower P/E ratio because of specific risks like high debt, which the P/E ratio does not take into consideration, or lower cash conversion, which can differ markedly from earnings because of accounting nuances.
Nonetheless, as a general indicator, the P/E ratio can serve as a starting point to value comparable shares, or to draw a comparison with the broader market.
The Price-to-Book ratio (P/B) forms a valuation based on a company’s assets listed on its balance sheet. It is most commonly used for mature, established companies where low growth is evident. In the eyes of the market, the higher the ratio, the lower ‘value’ the stock offers. If the P/B ratio is around 1 or lower, many consider this to be representative of ‘great’ value.
To calculate the P/B ratio, you must divide the current share price by the book value per share. To arrive at the book value per share, log into the research section of your SelfWealth share trading account. If you suspect a potential change in the total book value of a stock, which is its total assets less its total liabilities, you may wish to visit the company’s most recent balance sheet and make provisions based on these assumptions.
The Price-to-Sales ratio (P/S) prescribes a nominal value to the company for every dollar it generates in sales. It is particularly favoured for analysis of growth stocks that have yet to turn a profit. Alternatively, companies operating in a cyclical industry may be another suitable candidate since their profits can vary from year to year, or even turn into losses, despite stable sales.
You may work out the P/S ratio by dividing the company’s current valuation by the total sales it generated in the last year. A lower P/S ratio is viewed more favourably from a value perspective. Once again, metrics are likely to differ based on the industry. A dollar in sales earned in one industry may have more potential to deliver earnings than that in another industry. Valuation discrepancies may also be driven by consideration of debt, since the P/S ratio does not actively factor this in.
Final piece of the puzzle
While these ratios offer a convenient and practical approach to value shares, they shouldn’t be relied upon as an exhaustive solution. Not only is it wise to use a combination of these ratios, as well as others not discussed in this article, but it is prudent to consider the inherent traits of the stock you are analysing and the industry in which it operates.
Each of these ratios only offer limited insight into an area of focus. They do not necessarily explain valuation variances we see in similar companies. Ultimately, the share market is a subjective place, however, these ratios are designed to help simplify your due diligence before investing in shares.
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