Stock markets oscillate between extremes. Sometimes it is too optimistic and quotes prices too high and sometimes it is so pessimistic that it offers great businesses at throwaway prices. To make money in stocks you have to keep a tab on valuations of stocks you hold and of stocks you intend to buy in your portfolio. There are a few valuation tools you can use to ascertain if a stock you bought or about to buy is over-valued. Here are they:
Price to earnings ratio (P/E)
Also known as earnings multiple, this ratio is computed by dividing current market price of a stock by its Earnings per Share (EPS) of the stock. P/E ratio means how many times investors are willing to pay for a stock in the light of the earnings of the stock. P/E ratio can be based on the trailing 12 months earnings or can be calculated using forward estimates, if available.
This valuation parameter can be used for comparing two stocks. Higher the P/E ratio, costlier the stock if other variables remain the same.
Sometimes analysts compare prevailing P/E ratio with the average P/E ratio of a stock over a long period of time. If the prevailing P/E ratio is higher than the average then the stock has become costlier.
If you divide the P/E ratio by Earnings per Share (EPS) growth then you get PEG – Price to Earning to Growth Ratio. A number more than one is indicative of over-valued stock and less than one is under-valued stock.
Price to book ratio
Price to book ratio is used primarily for financials. Price to book ratio is computed by dividing the price per share by the book value per share. A lower P/B ratio means the stock is undervalued. A higher ratio indicates that the stock is overvalued. Compare the current number with the average and that of peers.
The effectiveness of P/B ratio depends on how the book value is computed. If accounting policies change, then the book value estimates also change. For new age companies, there are limited tangible assets which are easy to value. Most of their strength lies in intangible assets. In these cases, estimates can be far from reality and may offer distorted picture.
Price to sales ratio
This is one of the oldest valuation tools. This can be used for companies with no profits and not many real tangible assets. This ratio is computed by dividing current market price by sales per share. If the number is higher then the stock is overvalued and vice versa.
Dividend Yield
Dividend yield is calculated by dividing dividend per share by current market price. So if the dividend per share is Rs 4 and the stock is quoting at Rs 100, then the dividend yield is at 4%. Higher the dividend yield more is the stock undervalued. Lower the dividend yield means a stock is overvalued.
Dividend is a real cash payout to a shareholder. And hence it cannot be fudged. Most conservative investors look for companies paying regular dividends. They use this ratio extensively. High dividend yield acts as a support to stock prices in a falling stock market.
EV to EBITDA
Enterprise Value is calculated by adding short-and-long-term debt to the market capitalization of a company and then subtracting cash and near cash assets from it. If an investor has to take over the company, this is the money she has to pay to pay off all creditors / owners of the company.
Divide this number by EBITDA and you get the EV/EBIDTA. Higher the number indicates the intensity of overvaluation of a stock. For the uninitiated, EBITDA is Earnings before Interest, Taxes, Depreciation and Amortisation. It is also known as Operating Profits.
Value traps
When you are investing in a company, then you should value it right. But do not read too much into the number-driven valuation tools. Each number has multiple factors impacting it. A stock may be available at a low valuation for a reason. Some stocks exhibiting corporate governance issues are avoided by institutional investors and over a period of time they lack a strong demand resulting in low valuations. Stocks of companies in secular downward demand trends or in no growth industries, are available cheap. It is better to avoid them in the long-term.
As more and more investors embrace Environmental, Social and Governance (ESG)-based sustainable investing, stocks of companies that score low on ESG parameters may be ignored by investors. Such stocks are usually available cheap.
Identifying a valuation gap and buying a stock at the right price is a professional’s forte. You have to be very careful while analysing stocks from a valuation point of view. A stock attractively valued and bought at the right time, can be a good investment, if the market takes corrective action and offers high valuation to that stock.
Sometimes you may figure out that a stock is overvalued but selling in a hurry may not be a wise idea. Due to various factors, the stock may remain overvalued. For example, cheap money available due to low interest rates, rising stock markets, and booming economy may make investors chase stocks for higher returns. This may keep stock prices at elevated levels for a prolonged period of time.