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5 Valuation Metrics An Investor Needs To Know

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5 Valuation Metrics An Investor Needs To Know

For some, stock trading is tantamount to gambling, but it can be argued that investment is the art and science of making an informed decision about adding one's money into — or removing it from — an asset.

One essential approach that can come in handy in investment decisions is valuing the stock of a company using a standard formula.

Stock valuation is nothing but determining the intrinsic value of a stock, which most often is not in sync with the market price.

Why Valuation?

The calculation of this intrinsic value helps to decide the investability of the stock and can give a fair idea as to whether the market is overvaluing or undervaluing the equity. Valuation also helps predict future price movements so an investor can time their purchases or disposals.

Absolute Vs. Relative

Broadly, the valuation approach can be classified into absolute valuation and relative valuation, with the former taking into account the fundamental strength of the company, its dividends, its cash flows and its growth rate. The latter uses ratios.

Absolute valuation is most often estimated by calculating the net present value, or NPV, of the future cash flows of a company, aka the discounted cash flow, or DCF, model. Other methods include the dividend discount model, or DDM.

Relative valuation is used to compare the valuation of a stock relative to other stocks or the historical valuation of a company.

Most analysts prefer a cash-flow based valuation, especially buy-side analysts, according to Informit. That said, analysts complement their cash-flow based valuations with multiple-based valuations.

The logic behind relative valuation methods is that similar assets should trade at a similar price. Since several ratios can be used in relative valuation, it has become more popular among investors.

The following are a few key relative valuation metrics an investor can use in picking stocks.

1. Price-To-Earnings Ratio, Or P/E

Mathematically, the P/E ratio is obtained by dividing the market price of the stock by the earnings per share of the company. In other words, it is the price per unit of the current earnings or future earnings an investor pays.

It can be calculated as trailing P/E (the previous period's EPS is taken for calculation) or forward P/E (future EPS estimates are taken for calculation).

The P/E of a company in isolation may not ring a bell in the minds of investors; it has to be compared with either the historical P/E of the company or with the industry P/E. Instead of industry P/E, one can use the P/Es of peers or competitors.

If we take the case of Advanced Micro Devices, Inc. (NASDAQ: AMD), its forward P/E, is 27.39, according to the Yahoo database. This compares to the forward P/E of 10.28 for rival Intel Corporation (NASDAQ: INTC).

At the outset, the numbers may favor Intel, as it seems to be trading at a discounted valuation relative to peer AMD. Analysts, however, are apparently upbeat about the prospects of AMD and have baked the optimistic expectations into their models, which justifies a premium valuation relative to Intel.

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2. Price Earnings To Growth, Or PEG

The PEG ratio is calculated by taking the P/E ratio and dividing it by the projected growth rate for a particular company. Assuming that a company has a forward P/E of 15 and its earnings are expected to grow by 5 percent next year, the PEG ratio for the company would be 3.

A smaller PEG ratio suggests a stock is undervalued relative to its earnings growth expectations and vice versa. Taking the case of Intel and AMD, the latter may appear overvalued relative to the former in terms of the P/E ratio, but the PEG ratio argues for investing in AMD. The PEG ratio (using five-year growth) for AMD is 1.25 compared to Intel's 1.55.

3. Price/Sales, Or P/S

The Price/Sales ratio is calculated by dividing the market capitalization of the stock by the previous year's revenue. It gives an idea about how much an investor is paying for the stock per dollar of sales.

This ratio is most suited for evaluating companies belonging to cyclical industries that may not generate profits year after year. Unlike earnings, which can be influenced by accounting practices, sales are a fairly foolproof metric, and in this regard P/S is considered to be superior by many. That said, the ratio does not take into account the debt load of the company and could mislead investors into investing in a company saddled with debt.

4. Enterprise Value/Sales, Or EV/S

The EV/S ratio is obtained by dividing the enterprise value of the company — its equity plus debt, minus cash — by sales generated in the past year. Enterprise value reflects the minimum dollars that need to be paid to buy a company.

The EV/Sales is most suited to value early stage companies and high-growth companies that are barely making profits.

5. Enterprise Value/Free Cash Flow, Or EV/FCF

The ratio is calculated by dividing enterprise value by free cash flow, which is nothing but the operating cash flow minus capital expenditures. It tells us whether a company is overvalued or undervalued relative to the free cash flow it generates. The lower the ratio, the better.

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Points To Consider When Using Relative Valuation

  • Since relative valuation methods use metrics from financial statements, one should exercise caution in making the metrics comparable across companies.
  • Some ratios are more relevant for a particular industry. Therefore, it is important that the most apt ratio be used for valuing stocks belonging to a particular industry.
  • When valuing companies belonging to a sector or industry, other aspects such as growth potential, maturity of the business and size of the company should also be taken into consideration.
  • It is advisable to use multiple ratios rather than relying on one method for an accurate picture.

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