Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks. Let me discuss both types of valuations.
First, the fundamental valuation. This is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and is often drives the short-term stock market trends.
In short, there are many different ways to value stocks. I will list several of them here. The key is to take each approach into account while formulating an overall opinion of the stock. Look at each valuation technique and ask yourself why the stock is valued this way. If it is lower or higher than other similar stocks, then try to determine why. And remember, a great company is not always a great investment. Here are the basic valuation techniques:
Earnings Per Share (EPS). You've heard the term many times, but do you really know what it means. EPS is the total net income of the company divided by the number of shares outstanding. It sounds simple but unfortunately it gets quite a bit more complicated. Companies usually report many EPS numbers. They usually have a GAAP EPS number (which means that it is computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have adjusted the income to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts?
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. You can easily find historical EPS figures and to see forecasts for the next 1-2 years by visiting free financial sites such as Yahoo Finance (enter the ticker and then click on "estimates").
By doing your fundamental investment research you'll be able to arrive at your own EPS forecasts, which you can then apply to the other valuation techniques below.
Price to Earnings (P/E). Now that you have several EPS figures (historical and forecasts), you'll be able to look at the most common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios.
Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a chart of its historical P/E over the last several years (you can find on most finance sites like Yahoo Finance). Specifically you want to find out what range the P/E has traded in so that you can determine if the current P/E is high or low versus its historical average.
Forward P/Es are probably the single most important valuation method because they reflect the future growth of the company into the figure. And remember, all stocks are priced based on their future earnings, not on their past earnings. However, past earnings are sometimes a good indicator for future earnings. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar of fiscal year or two. I always use the Forward P/E for the next two calendar years to compute my forward P/Es. That way I can easily compare the P/E of one company to that of it's competitors and to that of the market. For example, Cisco's fiscal year ends in July, so to compute the P/E for that calendar year, I would add together the quarterly EPS estimates (or actuals in some cases) for its quarters ended April, July, October and the next January. Use the current price divided by this number to arrive at the P/E.
Also, it is important to remember that P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings (EPS) estimates change, be sure to recompute the ratio.
Growth Rate. Valuations rely very heavily on the expected growth rate of a company. For starters, you can look at the historical growth rate of both sales and income to get a feeling for what type of future growth that you can expect. However, companies are constantly changing, as well as the economy, so don't rely on historical growth rates to predict the future, but instead use them as a guideline for what future growth could look like if similar circumstances are encountered by the company. To calculate your future growth rate, you'll need to do your own investment research. The easiest way to arrive at this forecast is to listen to the company's quarterly conference call, or if it has already happened, then read a press release or other company article that discusses the company's growth guidance. However, remember that although company's are in the best position to forecast their own growth, they are not very accurate, and things change rapidly in the economy and in their industry. So before you forecast a growth rate, try to take all of these factors into account.
And for any valuation technique, you really want to look at a range of forecast values. For example, if the company you are valuing has been growing earnings between 5 and 10% each year for the last 5 years but suddenly thinks it will grow 15 - 20% this year, you may want to be a little more conservative than the company and use a growth rate of 10 - 15%. Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore you would want to forecast earnings growth closer to the 0 - 5% rate than the 15 - 20%. The point I'm trying to make is that you really need to use a lot of gut feel to make a forecast. That is why the analysts are often inaccurate and that is why you should get as familiar with the company as you can before making these forecasts.
PEG Ratio. This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio (a.k.a. Price Earnings to Growth ratio) divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it's traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process.
Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase it's future earnings growth for a lower relative price than that of Stock B.
Return on Invested Capital (ROIC). This valuation technique measures how much money the company makes each year per dollar of invested capital. Invested Capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent and you should look for a percent that approximates the level of growth that you expect. In it's simplest definition, this ratio measures the investment return that management is able to get for its capital. The higher the number, the better the return.
To compute the ratio, take the pro forma net income (same one used in the EPS figure mentioned above) and divide it by the invested capital. Invested capital can be estimated by adding together the stockholders equity, the total long and short term debt and accounts payable, and then subtracting accounts receivable and cash (all of these numbers can be found on the company's latest quarterly balance sheet). This ratio is much more useful when you compare it to other companies that you are valuing.
Return on Assets (ROA). Similar to ROIC, ROA, expressed as a percent, measures the company's ability to make money from its assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because of very common irregularities in balance sheets (due to things like Goodwill, write-offs, discontinuations, etc.) this ratio is not always a good indicator of the company's potential. If the ratio is higher or lower than you expected, be sure to look closely at the assets to see what could be over or understating the figure.
Price to Sales (P/S). This figure is useful because it compares the current stock price to the annual sales. In other words, it tells you how much the stock costs per dollar of sales earned. To compute it, take the current stock price divided by the annual sales per share. The annual sales per share should be calculated by taking the net sales for the last four quarters divided by the fully diluted shares outstanding (both of these figures can be found by looking at the press releases or quarterly reports). The price to sales ratio is useful, but it does not take into account any debt the company has. For example, if a company is heavily financed by debt instead of equity, then the sales per share will seem high (the P/S will be lower). All things equal, a lower P/S ratio is better. However, this ratio is best looked at when comparing more than one company.
Market Cap. Market Cap, which is short for Market Capitalization, is the value of all of the company's stock. To measure it, multiply the current stock price by the fully diluted shares outstanding. Remember, the market cap is only the value of the stock. To get a more complete picture, you'll want to look at the Enterprise Value.
Enterprise Value (EV). Enterprise Value is equal to the total value of the company, as it is trading for on the stock market. To compute it, add the market cap (see above) and the total net debt of the company. The total net debt is equal to total long and short term debt plus accounts payable, minus accounts receivable, minus cash. The Enterprise Value is the best approximation of what a company is worth at any point in time because it takes into account the actual stock price instead of balance sheet prices. When analysts say that a company is a "billion dollar" company, they are often referring to it's total enterprise value. Enterprise Value fluctuates rapidly based on stock price changes.
EV to Sales. This ratio measures the total company value as compared to its annual sales. A high ratio means that the company's value is much more than its sales. To compute it, divide the EV by the net sales for the last four quarters. This ratio is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times. For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant. However, by applying a EV to Sales ratio, you could compute what that company could trade for when it's restructuring is over and its earnings are back to normal.
EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company's cash flow and is used for valuing both public and private companies. To compute EBITDA, use a companies income statement, take the net income and then add back interest, taxes, depreciation, amortization and any other non-cash or one-time charges. This leaves you with a number that approximates how much cash the company is producing. EBITDA is a very popular figure because it can easily be compared across companies, even if all of the companies are not profitable.
EV to EBITDA. This is perhaps one of the best measurements of whether or not a company is cheap or expensive. To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the more expensive the company is. However, remember that more expensive companies are often valued higher because they are growing faster or because they are a higher quality company. With that said, the best way to use EV/EBITDA is to compare it to that of other similar companies.
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