There are two sides of the story of a company – one is what is happening inside the company (i.e. how good is the internal quality of the company) and the other is how the company is valued in the outside world (i.e. by the investors in the stock markets). Let’s see how to determine whether a company is overvalued or undervalued in the stock markets.
You might have heard about the concept of ‘value investing’. This is what we are basically going to learn about here. Benjamin Graham is credited to be the originator of this concept which has taken the form of a stream in itself in the world of investing. Many of the world’s greatest investors of our times including the likes of Warren Buffet, Peter Lynch, Seth Klarman, Joel Greenblatt, and Walter Schloss have followed this concept and have proved that value investing is the best and the most logical form of stock investing.
Value investing aims at buying at a price much lower than its value, ideally at half of what the stock is actually worth. A rational consumer always looks to buy anything at a bargain price or, if possible, at a good discount. This is what value investing is all about. Growth investors just focus on investing in companies having a high expected future growth rate. They do not care about the price they are paying. Value investing gives that much-needed level of comfort to investors as this policy ensures that they are not overpaying for the stocks they are buying. Value investing is a relatively safer way of investing. Value stocks are already available at a discount, and so they do not fall as much as overvalued stocks when the overall market is heading downwards. I personally have had a lot of success with value investing and strongly recommend it to my clients and readers. Pay less than necessary and sleep peacefully.
But why will somebody sell something at half its value? Because the world is not perfect or rational. Neither all stock investors behave rationally nor are all stocks fairly priced in the stock markets. Stock markets are full of irrational and uneducated (I am talking about investment education here) investors. In fact, most investors are irrational in their investing decisions. Fear and greed also play a major role in the markets. And so it is possible to find undervalued stocks and buy them cheaply. The aim is to buy stocks at less than their actual worth and sell them when the market realize their true value and the stock becomes overpriced. How to know whether a stock is undervalued? That’s where valuation ratios come into play.
Let us now start understanding the most important valuation ratios and how they can help us in finding undervalued stocks. Please note that none of these ratios provide a foolproof solution to the problem of valuing a stock accurately. These are mere indicators and so must not be used in isolation. It is best to use a combination of these to arrive at a better conclusion.
Price to Earnings Ratio
The most commonly used valuation ratio is the Price to Earnings Ratio, popularly called P/E ratio. This ratio compares the current market price of a stock with the earnings per share of the company.
Price to Earnings Ratio = Market Price Per Share (MPS) / Earnings Per Share (EPS)
Earnings Per Share (EPS) = (PAT – Preference Dividend) / Weighted Average No. of Shares Outstanding
Preference dividend is the dividend paid to preference shareholders. Preference shareholders enjoy preference in the payment of dividends, but cannot enjoy the benefits of capital appreciation that equity shareholders can enjoy. Deducting dividends paid to preference shareholders gives the amount of earnings left for equity shareholders.
A weighted average of the number of outstanding shares is taken with respect to the period for which these shares were floating in the market. Income is generated throughout the year. But if the number of outstanding shares changes close to the end of the year, taking the closing number of outstanding shares will give us a distorted picture. Hence a weighted average is preferred. Once we calculate the EPS we just need to divide the MPS with it to get the P/E ratio.
P/E ratio basically tells us how much we need to pay to get one rupee of the company’s earnings. So, if a company has a P/E ratio of 10, it means we are willing to pay ` 10 for each rupee of the future earnings of the company. In other words, if the company continues to generate the same amount of earnings we will get back our money in 10 years. Who would want to wait for so long just to get back his own money, and that too without interest? Nobody. But if the company is growing at a fast pace, then we can expect to get our money back and even generate a lot of profit in a relatively shorter period. This is what value investing is all about – investing in undervalued, fast-growing, fundamentally strong companies.
Obviously, the lower the P/E the better it is for an investor looking to put his money in a company. This would mean that the company is trading at a lower multiple of its earnings and is thus undervalued. But let me give you a word of caution here. Never judge a stock based purely on the basis of its P/E ratio. P/E relates to the past. The earnings have already been made and a prospective investor does not have any right on those earnings. It is the future that a prospective investor is concerned about. A low P/E may also mean that the other investors do not trust the company to generate good earnings in the future and something might be wrong internally. So a thorough examination of the company is necessary before investing. Some analysts try to predict the future earnings of companies and then calculate ‘forward P/E’ and take calls based on that. But I have not come across a single good method (including the commonly used DCF technique) that can predict the future with accuracy. I prefer to keep things simple and rely on an actual history than a doubtful estimate.
So what value of P/E should an investor look for? I basically look for companies having P/E ratio of less than 15. However, a P/E of less than 10 is what gives me the most amount of comfort.
PEG ratio is considered to be a refinement of the commonly used P/E ratio. ‘PEG’ stands for ‘price/earnings to growth’.
PEG Ratio = P/E ratio / Earnings Growth Rate
PEG ratio attempts to determine a stock’s value while taking the growth of its earnings into consideration as well. Hence it is considered to provide a more complete picture than the P/E ratio as it does not rely on absolute earnings of one year but considers the growth rate of earnings as well. This ratio was first given by Peter Lynch in his famous book, One Up on Wall Street.
We now understand how to calculate the P/E ratio. If we just factor in the company’s earnings growth rate we get the PEG ratio. Suppose the earnings of a company was ` 1.2 crore for the previous year and ` 1 crore for the year before, the earnings growth rate is 20%. If its P/E is 15, its PEG comes to 15/20 i.e. 0.75. In fact, you may want to use a historical growth rate in earnings for more than one year. For example, screener.in, a popular screening tool for Indian stocks, uses an average profit growth rate for the last 5 years to calculate PEG. This may give a better approximation of the average expected future earnings growth rate of the company.
Normally, if a company has a PEG of more than 1, it is considered to be overvalued and a company having PEG of less than 1 is considered to be undervalued. In other words, lower the PEG the better, unless, of course, if the PEG is negative signifying that the company in question is having a negative rate of growth. I don’t like to rely solely on valuation ratios and so I also consider companies having a PEG of greater than 1 but definitely not more than 2.
I like to calculate the PEG ratio on the basis of historical earnings and growth rate. You may, of course, attempt to predict future earnings (like many analysts do) but again its accuracy would be highly questionable. The accuracy rate of most analysts is less than 50%. Even a child can be right 50% of the time if asked whether a stock will move up or down tomorrow. Then what is the benefit of using fancy tools and software? I find it better to use actual historical figures in this calculation. There are better ways to predict the future prospects of the company and those must be taken into account by the investor before jumping to any conclusions. But making Balance Sheets and Profit and Loss Accounts for future and doing the calculations based on those predictions is not something I am very comfortable with.
Price to Book Value Ratio
In the first section of the book, I explained the difference between the book value of an equity share and market value of the share, and why their values are usually different. It is completely acceptable to have a difference between the book value and market price of a share, but the difference should be within acceptable limits.
Price to Book Value Ratio (P/B Ratio) = Market Price Per Share / Book Value Per Share
P/B ratio basically shows the ratio of the market value and book value of a share of a company. Its basic interpretation says that if the value of P/B ratio is less than 1, the company is undervalued and if it is more than 1 the company is overvalued.
But this interpretation must be taken with a grain of salt. Book values are affected by accounting policies and entries into the account books. Also, assets are valued at historical costs. These may make book value quite unreliable when making investing decisions. Many modern value investors, including Peter Lynch and Warren Buffet, give limited importance to this ratio. And they are justified in doing this. Book values can ignore intangible assets or value them inaccurately. The depreciation rates may also not show the correct picture. The tax effects and methods of recording R&D expenses may also pose a distorted image.
Also, the value of P/B ratio could be low as the investors are of the opinion that the value of equity in the books is flawed. Again, if the company has overvalued its assets or undervalued its liabilities in its account books, the financial statements would show an inaccurate picture of the state of affairs of the business. So it is important to take the help of other ratios as well and not rely fully on P/B to value a stock.
Although book values are not accurate, they may be a pretty reliable approximation of the value of a company’s equity. The accounting policies are becoming more transparent and regulators are trying to make sure that companies report their financials properly. Also, since we will not be relying entirely on P/B ratio to make our investment decisions it may only serve as an extra tool to help us invest in undervalued stocks.
I like to be a little more lenient in relying on P/B ratio. There are hardly any good companies the market prices of which are less than their book values. So it is difficult to find a good company to invest in whose P/B ratio is less than 1. I look for companies that have a maximum P/B of 4. Going beyond that makes me uncomfortable. In any case, I never invest in a company having a P/B ratio of more than 7.
Something to Note
It is often argued that seemingly undervalued companies are fundamentally weak and that is the reason they are available cheap in the markets. This argument is not entirely incorrect. If a company has a low P/E ratio it doesn’t always mean that it is undervalued. Low P/E stocks are often found be unworthy of an investor’s look. What is needed is a method that can enable an investor to separate the wheat from the chaff. Putting a good valuation into the mix makes sure that you pay a favorable price for a good stock giving you a major advantage and limits your risk.
How to use all this information
There are many other valuation ratios that I could have talked about here viz. price to sales, price to cash flows, price to free cash flow, price to cash EPS, cash to market cap, enterprise value to EBITDA, and so on. But I like to keep things simple (didn’t I say that earlier?). The three ratios discussed in this article are enough for anybody looking for undervalued companies in the stock markets. You can consider companies that have a maximum P/E ratio of 20, maximum PEG ratio of 2 and maximum price to book value ratio of 7. Simply eliminate the rest and test your list on the other metrics discussed in this book. Do this and you will be well on your way to find some great undervalued companies to invest in. And the lesser is the market cap of the companies the stricter should be the criteria of valuation ratios.
Valuation is just one of the many aspects of a company that an investor needs to pay attention to while selecting stocks. Some of these aspects are
- Cash Flows (Read: How to Analyze Cash Flow Statements)
- Product Sustainability,
To learn about the various aspects of successful stock picking and investing, you can buy my book: SIMPLE INVESTING – A Stock Investor’s Handbook.
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