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Valuations

A valuation is one of two sides to a stock that is often overlooked by individual investors.

When analyzing a company, you can look at the quality of the business and the price you pay for that business.

Many investors, unfortunately, just look at the quality of a business (which includes growth potential, quality management and advantages over competitors).

However, contrary to what many think, it is not strictly the quality of a business that makes the stock do well, but the ratio between quality and valuation.

Understandably, for a low quality company, you expect to pay a low valuation in a fair world. For a high quality company, you expect to pay a high valuation.

However, sometimes, even when accounting for the quality of a company, the valuation may be off what it should be in a fair world.

For example, a mediocre quality company may warrant a cheap valuation but the valuation is currently extremely cheap, not just cheap. Therefore, it might be a good buy. On the other hand, a good quality company might warrant a high valuation, but it is currently trading at an extremely high valuation, meaning the stock might actually go down.

The conclusion from this is that we should not merely be thinking about which businesses will grow a lot in the future, but the ones who will perform a lot better than their expectations assumed in their valuations. If a bad quality company is valued under the assumption of no growth at all, and then grows by just a couple percent, that stock will do very well.

Likewise, if a great quality company is expected to grow by 200% but “only” grows by 150%, the stock might actually go down. Your mentality should be:

“where are investors the most wrong about the company’s long-term profit potential”.

Valuations

The 2 most common methods to value a company are by using multiples or doing a discounted cashflow. The latter tends to be more accurate and detailed, however that requires a lot of learning before you can do it.

Valuations by multiples, although not perfect, are able to give you a rough estimate, quick and dirty, type of valuation. While maybe making it difficult to accurately state what a stock should be priced at, it can easily point out clear buying and selling opportunities.

Multiple 1 : Price to Earnings Ratio (PE ratio)

This is the most common ratio, it’s the price you pay per share for every dollar of yearly profit per share. Therefore, if the PE ratio is 20, you pay 20e for every 1e of earnings the company has.

A basic assumption would be that the higher the multiple, the more expensive the stock is. However, this is a bit simplistic. It depends on the profit growth potential of the company. If a company has the potential to grow very fast, you may be willing to spend an expensive valuation today because the company will earn so much profit in the future.

Likewise, if the company’s profit is growing very slowly, you may only be willing to value the company at a low valuation. This is why companies in the same sector might have very different multiples, and justifiably so — they may have very different growth prospects.

Multiple 2: Price to Book Ratio (PB Ratio)

The book value of a company is what you’d be left with if you sold off all the things the company owns (the assets), and paid off everything the company owes (the liabilities).

The PB ratio is the price per share divided by the book value per share. You may be asking why the price per share is not equal to the book value per share (if they’re equal, the ratio is 1). The ratio is often more than 1 because you’re paying more than the company is worth on paper because you’re anticipating receiving all the future profit, besides owning the book value of this company. Sometimes the book value is below 1.

This implies that investors think that if the company sold its assets and paid its liabilities, it would probably be left with less than the accounting book value. This could be because some assets might be hard to sell at prices listed in the accounts, some might be unsellable (like hardware you made specifically for your company — it might not be useful for any other company), and so on.

Again, a higher multiple implies a more expensive valuation but again, you need to take into account the profit growth potential of the company. It is fine for a better company to trade at a higher multiple, just not too high.

This multiple is best for companies that rely on its assets to make money, like a factory. A company like Google, which doesn’t own many assets, will have an artificially high PB ratio which may be unrepresentative of valuation.

Multiple 3: Price to Sales Ratio (PS Ratio)

This is the price per share divided by the revenue per share. Sometimes, a company might be making losses so you can’t really use a PE ratio. However, the revenue is still there, so you can calculate this multiple with the anticipation that eventually the company will make profit again.

Same assumptions apply for the above two multiples, higher multiples imply higher valuations but again you need to take into account profit growth potential.

How to Use the Multiples

You know how to calculate the multiples for a company, now what?

The best thing to do is compare the current multiples for the company against, firstly, the competitors right now, and secondly, the same company over time. For the former, let’s say we’re looking at car companies:

Let’s say all car companies trade at a PE ratio of about 10 but BMW trades at a multiple of 8. This might signal that BMW is too cheap. However, you have to take into account that maybe a multiple of 8 is justified (if BMW is expected to be lower in growth and profitability than competitors.

If you think it should be somewhat the same as competitors profit wise, then it is too cheap. You can also compare to the company over time. Let’s say on average across many years, Barclays bank has a PB of 1. Today the multiple could be 0.5. That could mean it’s too cheap, but again be careful. Maybe it’s fair for Barclays to trade at a multiple of 0.5 compared to the past because it is a lot less profitable today and faces a bleaker future.

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Disclaimer:
Any views or opinions presented in this article are personal and shouldn’t be taken/used as professional advice as we are not qualified financial advisors.
Any statistics mentioned have all been linked to their respective documents together with their ownership.
Lastly, we would like to note that this article has no tie to our professional jobs and was conducted in our free time.