Learn stock valuation techniques – Pay close attention to the price you pay for a stock and you minimize your speculative risk. Focus instead on investment returns.
Tag: Beginner Investor
Stock Analysis | Learn to analyse a stock in-depth
Learning stock analysis can be a daunting task for newbie investors. Here’s a complete step by step, do-it-yourself template for conducting in-depth stock analysis
Understanding Cash Return ratio
The best yield-based valuation measure is a relatively little-known metric called Cash Return ratio. In many ways it’s actually a more useful tool than the P/E.
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Cash Return ratio
The best yield-based valuation measure is a relatively little-know metric called Cash Return ratio. In many ways it’s actually a more useful tool than the P/E. To calculate cash return, divide free cash flow by enterprise value.
Cash Return Formula
Cash Return = Free Cash Flow/Enterprise Value = Free Cash Flow/(Market Cap + debt – Cash)
The goal of Cash Return is to measure how efficiently the business is using its capital –both equity and debt-to generate free cash flow. Essentially cash return tells you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole shebang, including the debt burden.
The best yield-based valuation measure is a relatively little-know metric called Cash Return ratio. In many ways it’s actually a more useful tool than the P/E. To calculate cash return, divide free cash flow by enterprise value.
Cash Return is a great first step to finding cash cows trading at reasonable prices.
You may also like to learn more on yield-based and other valuation measures, as below.
Understanding Earnings Yield
The nice thing about Earnings Yield, as opposed to P/E, is that we can compare it with alternative investments such as fixed deposits, to see what kind of a return we can expect from an investment.
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Earnings Yield
The first yield based measure is what is called the Earnings Yield. In addition to multiple-based measures, you can also use yield-based measures to value stocks. If we invert the P/E and divide a firm’s earnings per share by its market price, we get an earnings-yield. If a stock sells for Rs. 200 per share and has Rs.10 in earnings, it has a P/E of 20 (20/1) but an earnings-yield of 5% (1/20).
Earnings Yield Formula
Earnings Yield = Earnings per share / current market price
The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments such as fixed deposits, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas fixed deposit payments are fixed).
A stock with a P/E of 20 would have a yield of 5 percent which is worse than the current bank FD rate of 8%. A stock with a P/E of 10, however, will have a yield of 10% which is better than the FD rates. Thus I might be induced to take the additional risk.
You may also like to learn more on yield-based and other valuation measures, as below.
Understanding Price to Sales ratio
The Price to Sales ratio (P/S) is useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios
Price to Sales ratio
The most basic ratio of all is the Price to Sales ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. In addition sales are not as volatile as earnings –one time charges can depress earnings temporarily, and the bottom line of economically cyclical companies can vary significantly from year to year.
Price to Sales Formula
Price to Sales = Current stock price /Sales per share
This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.
However the P/S ratio has one big flaw. Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions , but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio, because we have no idea what level (if any) profits the company will generate.
Therefore, although the P/S ratio might be useful if you are looking at a firm with highly variable earnings –because you can compare today’s P/S with a historical P/S ratio – it’s not something you want to rely on very much. In particular don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.
You may also like to learn more on other valuation measures, as below.
Understanding Price to Book ratio
Although Price to book ratio (P/B) still has some utility today, the world has changed since Ben Graham’s day. Find out how to use P/B as a valuation measure for today’s markets.
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Price to Book ratio
Another common valuation measure is price to book ratio (P/B), which compares a stock’s market value with the book value (also known as shareholder’s equity or net worth) on the company’s most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now. Legendary value investor Benjamin Graham, one of Warren Buffet’s mentors, was a big advocate of book value and P/B in valuing stocks.
Price to Book Formula
Price to Book = Current Market Price/Book Value per share
Although price to book ratio still has some utility today, the world has changed since Ben Graham’s day. When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in book value.
For service firms in particular Price to book ratio has little meaning. If you used P/B to value eBay, for example, you wouldn’t be according a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful. Price-to-book may also lead you astray for a manufacturing firm such as 3M, which derives much of its value form its brand name and innovative products, not from the size of its factories or the quantity of its inventory.
Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm’s tangible book value and the purchase price is called goodwill, and its supposed to represent the value of all the intangible assets –smart employees, strong customer relationships, efficient internal processes –that made the target firm worth buying. Be highly skeptical of firms for which goodwill makes up a sizeable portion of their book value.
Price to Book & Return on Equity
Price to book ratio is also tied to Return on Equity (equal to net income divided by book value) in the same way that price-to-sales is tied to net margin (equal to net income divided by sales) . Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at P/B, make sure you relate it to ROE.
A firm with low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you will want to do some digging before making that assessment based solely on the P/B.
Price to Book – valuing Financial Services firms
Although P/B isn’t very useful for service firms, its very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. The nice thing about financial firms is that many of the assets included in their book value are marked-to-market –in other words they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current. (A factory or a piece of land by contrast, is recorded on the balance sheet at whatever value the firm paid for it, which is often very different form the asset’s current value). As long as you make sure that the firm does not have a large number of bad loans on its books, P/B can be a solid way to screen for undervalued financial firms.
You may also like to learn more on other valuation measures, as below.
Understanding Dividend Yield
Dividend yield is an easy way to compare the relative attractiveness of dividend-paying stocks. It tells us the return we can expect by purchasing a stock vis-à-vis bonds, FDs, etc.
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Dividend Yield
A popular yield based measure used to value stocks is the dividend yield. It allows investors to compare the latest dividend they received with the current market value of the share as an indicator of the return they are earning on their shares. Note, though, that the current market share price may bear little resemblance to the price that an investor paid for their shares.
Dividend Yield Formula
Dividend Yield = Latest Annual Dividends per share/Current market price per share
Dividend Yield is thus an easy way to compare the relative attractiveness of various dividend-paying stocks. It tells an investor the return he / she can expect by purchasing a stock and can thus be compared with other investments such as bonds, certificates of deposit, etc. Investors who look to secure some regular income from their investments can do so by investing in stocks paying relatively high, stable dividend yields.
For example, if two companies both pay annual dividends of Rs.10 per share, but company A’s stock is trading at Rs.200 while company B’s stock is trading at Rs.400, then company A has a dividend yield of 5% while company B is only providing an yield of 2.5%. In this case, if we assume all other factors are equivalent, investors looking to supplement their income would likely prefer company A’s stock over that of company B.
Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower yield. Many fast growing companies do not have a dividend yield at all because they do not pay out dividends as they reinvest all the cash in expanding the business.
What to look for while analysing a stock’s dividend yield
A high dividend yield may be an indication of a stock’s current attractiveness. However this can be misleading, if not sustained. Look at the dividend paying history of the company of last 5 years. A track record of maintaining and/or increasing dividends per share over the years is one indication of sustainability of dividends. A consistent dividend payout ratio for a firm with stable growth offers better clues towards sustainability of dividends.
You may also like to learn more on yield-based and other valuation measures, as below.
Understanding and using PE ratio
The PE ratio is the most commonly used stock valuation measure. It compares the price of a share to the company’s earnings per share (EPS)
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PE Ratio
Now we come to the most popular valuation measure- the Price to earnings ratio or the PE ratio, which can take you pretty far as long as you are aware of its limitations. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value. Moreover earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
Price to Earnings Formula
Price to Earnings = Current Market Price/Earnings per share
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations. A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which effect the Price to earnings ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
You can also compare a stocks P/E to the average P/E of the entire market. However the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company’s P/E with industry peers or with the market has some value, but these aren’t approaches that you should rely on to make a final buy or sell decision.
However comparing a stock’s current P/E with its historical Price to earnings ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.
This method works generally with more stable, established firms than with young companies with more uncertain business prospects. Firms that are growing rapidly are changing a great deal from year to year, which means their current P/Es are less comparable to their historical P/Es.
P/E drawbacks
Relative P/Es have one huge drawback. A PE ratio of 12, for example, is neither good nor bad in a vacuum. Using PE ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. (peer, industry, market).
So, let’s try to look at the PE ratio on an absolute level. What factors would cause a firm to deserve a higher PE ratio? Because risk, growth, and capital needs are all fundamental determinants of a stock’s PE ratio, higher growth firms should have higher PE ratios, higher risk firms should have lower P/E, and firms with higher capital needs should have lower P/E. We can see why this is true, intuitively.
Firms that have to shovel in large amounts of capital to generate their earnings run the risk of needing to tap additional funding, either through debt (which increases the risk level of the company) or through additional equity offerings (which may dilute the value of current shareholders’ stake). Either way, its rational to pay less for firms with high reinvestment needs because each dollar of earnings requires more of shareholders’ capital to produce it.
Meanwhile, a firm that’s expected to grow quickly will likely have a larger stream of future cash flows than one that’s growing slowly, so all else equal, it’s rational to pay more for the shares (thus the higher Price to earnings ratio). On the flip side, a firm that’s riskier –maybe it has high debt, maybe it’s highly cyclical, or maybe it’s still developing its first product –has a good chance of having lower future cash flows than we originally expected, so it’s rational to pay less for the stock.
When you are using the Price to earnings ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means that a reasonable PE ratio will be somewhat higher than for a run-of-the mill company. The same goes for firms with higher growth rates, as long as that growth isn’t being generated using too much risk.
Some other aspects that can distort PE ratios
A few other things can distort a PE ratio. Keep these questions in the back of your mind when looking at P/E, and you’ll be less likely to misuse them.
Has the firm sold a Business or an Asset recently?
If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have artificially inflated earnings, and thus a lower P/E. Because you don’t want to value the firm base don one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.
Has the firm taken a big charge recently?
If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, its useful to add back the charge to get a sense of the firm’s normalized P/E.
Is the firm cyclical?
Firms that go through boom and bust cycles –commodity companies, auto manufacturers are good examples –require a bit more care. Although you will typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.
Does the firm Capitalise or Expense its Cash flow generating assets?
A firm that makes money by inventing new products –drug firms are the classic example- has to expense all of its spending on research and development every year. Arguably, it’s that spending on R&D that’s really creating value for shareholders. Therefore, the firm that expenses assets will have lower earnings –and thus a higher P/E- in any given year than a firm that capitalizes assets. On the other hand, a firm that makes money by building factories and making products gets to spread the expense over many years by depreciating them bit by bit.
You may also like to learn more on other valuation measures, as below.
Understanding Quick Ratio
Quick Ratio is a more conservative measure of a firm’s short-term liquidity than Current Ratio. It is especially useful for analysing manufacturing firms and retailers.
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Quick Ratio
The Quick Ratio is a more conservative test of a company’s liquidity, than the Current Ratio We have learnt that a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble. Unfortunately, some current assets – such as inventories – may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year’s fashions to generate cash – you would be unlikely to receive anything close to what you paid for them.) Current assets less inventories, divided by liabilities equals Quick Ratio.
Quick Ratio formula
Quick Ratio = (Current assets – Inventories)/Liabilities
In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company’s short-term financial strength. By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs. It is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Calculating Quick Ratio
Quick Ratio is simply calculated by subtracting Inventories from Current Assets and dividing the result by Current Liabilities. Inventories, Current Assets and Current Laibilities can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year. There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, spare parts and finished products that have not yet been sold.
Rough benchmarks for analysing a stock’s Quick Ratio
In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look to other firms in the same industry to be sure.
You may also like to learn more on other financial strength measures, as below.
Understanding Times Interest Earned
Times Interest earned (also known as Interest Coverage) is a measure of a company’s ability to meet its debt obligations.
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Times Interest Earned
Times Interest Earned is also known as “Interest Coverage” ratio. Look up pretax earnings, and add back interest expense- this gives earnings before interest and taxes (EBIT). Divide EBIT by interest expense, and you will know how many times the company could have paid the interest expense on its debt. The more times the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.
Times Interest Earned Formula
Times Interest Earned = Profit before Interest & Taxes (PBIT)/Interest Expense
Calculating Times Interest Earned
Times Interest Earned is simply calculated by adding Profit Before Tax (PBT) and Interest charges and dividing the result by Interest charges. Both Profit before Tax and Interest charges can be taken from the Profit and Loss Statement from the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Interest charges includes interest cost for the debt carried by a company and other charges such as financial transaction fees.
Rough benchmarks for analysing a firm’s Interest Coverage
It is tough to say how low this metric can go before you should be concerned -but higher is definitely better. You want to see higher Interest coverage for a company with a more volatile business than for a firm in a more stable industry. Be sure to look at the trend in Interest coverage over time as well. Calculate the ratio for the past 5 years, and you will be able to see the company is becoming riskier -Interest coverage is falling – or, whether its financial health is improving.
You may also like to learn more on other financial strength measures, as below.