Stock valuation can be a complex topic. It is difficult to know which metrics to use and why as well as what they mean.
Furthermore, there are often disadvantages to each valuation metric that are rarely discussed. Different types of stocks use different fundamental analysis metrics.
Understanding a stock’s intrinsic value can give you an edge when buying shares and making investment decisions.
In this article, we’ll look at the seven most popular valuation methods and how to use them, as well as pitfalls to look out for when beginning to value a stock.
How to value a stock in 7 steps
- Understand your valuation metrics
- Calculate the earnings per share (EPS)
- Determine the price to earnings ratio (P/E)
- Analyse the forward P/E
- Consider the price to earnings to growth ratio (PEG)
- Analyse the company’s Enterprise Value (EV)
- Check the company’s Dividend Yield (DY)
1. Understand your valuation metrics
Understanding valuation metrics and knowing if a share is priced expensively or cheaply is a useful skill. We wouldn’t pay £350 for a TV if it was sold regularly elsewhere at £300.
Likewise, when we buy a house we don’t just buy it without doing any research.
We want to know a stock’s book value and we want to pay a fair price for it. Nobody wants to get ripped off – nor should they be if we know the important fundamental analysis metrics to consider.
Stocks are no different, and knowing what a company is worth and what we’re paying is crucial when it comes to understanding value.
As Warren Buffet says:
“Price is what you pay, value is what you get”
If we want good value for our money we need to understand the basic valuation metrics and techniques so we can apply them to our shares.
2. Calculate the earnings per share (EPS)
Understanding how to calculate earnings per share is necessary because we can use it to compare against the company’s previous earnings.
Most people believe that the best way to check how a company is doing is to see how much profit it is making. This is a good start, but it is earnings per share, or EPS, that matters the most.
First of all, we need to understand the concept of earnings per share.
What is earnings per share?
Earnings per share tells us the amount that each share gets as a portion of a company’s earnings. We can then use earnings per share to calculate other investment metrics as well as use them to compare previous earnings for the same company.
How to calculate earnings per share for a stock
We can calculate earnings per share by taking the net income (also known as net profit or profit after tax) and dividing this by the number of shares in issue (also known as outstanding shares).
The calculation for earnings per share is simple and straightforward.
Many novice investors make the mistake of looking at profit for the company as a measure of its performance.
However, this can be disastrous because if the number of shares in issue increases, then this dilutes the amount of earnings that we are entitled to. Earnings per share tells us how much profit we are entitled to for each share we own.
Example of earnings per share
Aerotyne International makes a profit of £1,000,000 in Year 1. The business makes a profit of £1,500,000 in Year 2. Going into Year 3 the business is expected to make a total of £2,250,000.
On the other hand…
Solid Carburettor makes a profit of £1,000,000 in year 1. In Year 2 the business makes a profit of £1,250,000, and is forecast to make £1,400,000 in Year 3.
Which stock of the two businesses would you rather buy?
Aerotyne International grew profit at 50% year-on-year, whereas Solid Carburettor grew at 25% from Year 1 and then less than 10% from Year 2 to Year 3.
Clearly, Aerotyne International is the better choice using the above information.
However, let’s dig a little deeper at Aerotyne International.
Aerotyne International achieved a net profit of £1,000,000 in Year 1 but the board did not expect to achieve any growth in Year 2. The board decided to acquire a business that would give them further growth.
In Year 2 they bought Winchester Disk Drives which made £500,000 of profit.
Aerotyne International had 100,000 shares in issue, however, they issued a further 100,000 shares to pay for Winchester Disk Drives in equity, creating further dilution.
Once the transaction was complete Aerotyne International realised that their acquisition was not as great as it had looked because they had not undergone proper due diligence, and Winchester Disk Drives was only forecast to breakeven in Year 3.
They decided to properly do their due diligence this time and acquire Stratton Technologies, which was projected to and made £750,000 in profit in Year 3.
To do this, Aerotyne International paid for Stratton Technologies in equity again, issuing another 200,000 shares bringing the total to 400,000 shares.
The key point to be aware of here is not the profit but the share count.
Let’s see how Solid Carburettor grew their profit:
Solid Carburettor made a profit of £1,000,000 in Year 1, and did not acquire any businesses in Year 2. The business is able to fund itself and grow from existing cash flows and made net profit £1,250,000 in Year 2, and £1,400,000 in Year 3.
Solid Carburettor tarted with 100,000 shares and did not issue any more shares over the three years.
Now which business did you choose?
If you’re unsure, let’s look at how net profit and earnings per share changed in each year…
|Aerotyne International||Solid Carburettor|
|Year 1||£1,000,000 / 100,000 shares|
= 1000p EPS
|£1,000,000 / 100,000 shares|
= 1000p EPS
|Year 2||£1,500,000 / 200,000 shares|
= 750p EPS
|£1,250,000 / 100,000 shares|
= 1250p EPS
|Year 3||£1,750,000 / 400,000 shares|
= 437.5p EPS
|£1,400,000 / 100,000 shares|
= 1400p EPS
Aerotyne International looked far more appealing looking at the net profit, but actually, Aerotyne’s shareholders have been earning less per share, with EPS down from 750p in Year 2 to 437.5p in Year 3!
This is because Aerotyne International diluted its shareholders in order to purchase growth, whereas Solid Carburettor did not dilute its shareholders at all.
The above example shows exactly why earnings per share is more important than net profit for the company to the private investor.
The amount of shares outstanding increasing means reduced earnings per share, commonly referred to as ‘dilution’.
Why do companies dilute shareholders?
Companies can issue stock for many reasons: to acquire a business, to raise more cash (mostly for this), or to incentivise management.
When investing in small caps we must be aware that shareholder dilution can be a necessary evil; many of the companies that trade on the stock market are not profitable and so to continue operating they need to raise more cash.
Stock raised in these equity issues is usually at a discount to the current price which makes it attractive for new investors but less appealing for current shareholders.
This is because the lower the share price of the new shares that are being raised the less cash the company will receive, and so it is in current shareholders’ interests to have the price as high as possible to minimise dilution.
Example of dilution
If we own two shares of £1 in a company that is worth £10, we own 20% of the company.
However, if the company decides to raise £5 more in cash for equity and sells to another investor ten shares for 50p, we will own two shares of twenty (10% of equity – we have been diluted from 20% to 10%).
If the company had managed to sell five shares for £1 then we would have two shares of fifteen (13.3% of equity) and yet the company would have raised the same amount of cash (£5). It is in the company’s best interests for current shareholders to raise new shares at a price as high as possible and minimise dilution.
Not all equity issues are bad but we should be wary of buying shares into a company that is not yet profitable. Unless they have more than enough cash on the balance sheet to reach profitability it is likely they will need to dilute.
The best way to avoid dilution is to only buy shares in businesses that are profitable and cash generative.
We can also use earnings per share to value the shares using valuation metrics.
3. Determine the price to earnings ratio (P/E)
In this section, we’re going to look at the price to earnings ratio and the pros and cons of using this valuation metric.
What is the P/E ratio?
The price to earnings ratio, also known as the P/E ratio, or PER, is the ratio of a company’s share price to the company’s earnings per share.
We can use the P/E ratio to value companies and to see the earnings multiple the market currently values the stock.
How to calculate P/E
Calculating a company’s P/E is straightforward. We take the company’s price and divide this by its earnings per share.
This then tells us what the market is paying for the company’s earnings. If a stock has a P/E ratio of 10, then we know that the market is currently valuing the company’s stock at a price of 10x its earnings.
However, P/E has both some advantages and disadvantages…
Advantages of P/E
One advantage of P/E is that it gives us a quick indication of the market’s sentiment towards the stock.
For example, if a company has a P/E of 2 then we know it’s trading at 2x earnings. That means–assuming all things stay equal–the company will earn its share price in profits in two years.
However, nothing ever stays equal, and the company could well be a “value trap”.
Disadvantages of P/E and “value traps”
One problem of P/E is that whilst it tells us the ratio that the market current values the shares, it doesn’t tell us whether that valuation is justified or not.
Many investors make the mistake of thinking that a low P/E equals a cheap stock. That is not the case.
Let’s consider a stock that has 1,000 shares priced at 1000p, and the stock had earnings per share of 250p. That gives the stock a P/E ratio of 4 and would make the company cheap if we only looked at P/E ratio.
However, next year the share price has nearly halved to 600p and EPS has fallen 20% to 200p. The company is now even cheaper! It trades on a P/E of 3.
But is this the stock we would want to own?
The company trades on a lower P/E because the share price is falling faster than its profits.
Value traps like this are not uncommon in low P/E stocks and eventually, when they become loss-making they won’t have a P/E at all.
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4. Analyse the forward price/earnings ratio (forward P/E)
As well as the P/E ratio, we can look at the forward price/earnings ratio in order to provide further valuation context on the stock.
In this section, we’ll look at the forward P/E in more detail.
What is the forward P/E ratio?
The forward P/E ratio is similar to the P/E ratio only with forward P/E we use a stock’s current price over its predicted earnings per share.
We can use a stock’s consensus earnings per share as the predicted value in order to calculate what P/E ratio a stock will trade on at next year’s expected earnings per share.
Consensus earnings estimates refer to either the average or the median forecasts of the group of analysts that cover the stock at that point in time.
However, this is a prediction and analysts are not infallible and can often be wrong.
How to calculate forward P/E
Calculating a company’s forward P/E is very similar to calculating a company’s P/E. We take the company’s current share price and divide this by its consensus earnings per share for the following year…
This then tells us what the market is paying for the company’s predicted earnings.
If a stock has a forward P/E ratio of 8, then we know that the market is currently valuing the company’s stock at a price of 8x its future predicted earnings.
When using forward P/E if a stock’s earnings are expected to increase, then we would see a fall in the forward P/E against the current P/E.
If a stock’s forward P/E is higher than the current P/E of the stock then it tells us that the consensus earnings for the stock are expected to decline.
Like P/E ratio, forward P/E also has the downside that it only determines the sentiment of the market purely for the stock’s earnings.
Neither of these P/E ratios determines the quality of the stock’s earnings in terms of its earnings growth. For that, we need to look at a stock’s PEG ratio…
5. Consider the price to earnings to growth ratio (PEG)
Unlike P/E and forward P/E, the PEG ratio considers the price the market is paying for a stock’s earnings in terms of its actual earnings growth.
This gives us an even better idea of a stock’s valuation…
What is the PEG ratio?
The PEG ratio is the price to earnings to growth ratio. This ratio takes the company’s current P/E ratio and measures this in terms of the company’s earnings growth.
How to calculate PEG
The price/earnings to growth ratio, or PEG ratio, is calculated by taking a stock’s PE ratio and dividing this by its percentage growth rate in earnings.
Generally, the market values those companies with a higher P/E ratio because the company is expected to have a higher growth rate.
Using P/E ratio alone would then mean that higher growth companies appear more overvalued compared to lower P/E companies.
The PEG ratio allows us to look at all companies, irrespective of their P/E ratio, and analyse their valuations compared to their growth rates.
The PEG ratio was popularised by legendary investor Peter Lynch, who wrote in his 1989 book One Up on Wall Street:
“The P/E ratio of any company that is fairly priced will equal its growth rate”
This means that any company that is fairly valued will have a PEG ratio of 1.
To give an example, a stock that is valued on a P/E ratio of 10x times and is growing its earnings at a percentage growth rate of 10% will have a PEG ratio of 1.
Anything less than 1 suggests that the company could be undervalued (though one should never use PEG alone when conducting a fundamental valuation), and a PEG ratio of above 1 could suggest that the valuation is frothy.
High P/E ratios
Private investors are often scared away from high P/E ratios, and for good reason. Lofty earnings multiples can come crashing back down to earth once reality sets in.
However, for the investor willing to take on more risk and pay premiums for high quality growth stock then huge returns can be made
Sometimes companies grow into their forward P/E ratios and eventually, in hindsight, we realise that they were not expensive at all. They were just priced higher because of their growth rate. We wouldn’t pay the same price for a Fiat as we would a Ferrari.
Be aware when buying high P/E stocks that if the quality is substandard, you will be in for a nasty shock. Check what is under the hood, and kick the tyres.
Some of the best stocks on the market trade with lofty P/E multiples, but not all high P/E ratio stocks are the best stocks on the market. The difference is in the projected growth and quality of earnings. Not all profits are equal.
The PEG ratio allows us to analyse what the market is paying in terms of a stock’s P/E ratio but also takes into account the actual percentage growth rate of the company’s earnings per share.
6. Analyse the company’s Enterprise Value (EV)
Another method we can use to value a company is to look at the Enterprise Value (EV) of the company…
What is the Enterprise Value (EV)?
The enterprise value is a useful metric to check the real value of the company. It is the total value that someone would actually be paying for the company if they were to buy it.
When Woolworths went into administration in 2008 it was available for sale for £1. That was the market value of the company.
However, the market value didn’t take into account all of its debt, which was the very reason Woolworths went bust!
The enterprise value gives us a much more accurate valuation of the company than the market capitalisation of the company.
A final advantage of EV is that it strips out intangible assets and only looks at cash.
How to calculate E/V
The Enterprise Value (EV) of a company is calculated by taking the market capitalisation of the company, adding the sum of its total debt, and subtracting its total cash.
The enterprise value is the total value that a buyer would receive for the company factoring in its debt and cash if they were to buy the business.
Let’s consider Company A and Company B, both of which are valued with a market capitalisation of £100 million.
However, Company A has £20 million of net cash on the balance sheet and Company B has £50 million of net debt on the balance sheet.
This significantly changes what a shareholder is getting when they buy the stock.
Company A would have an EV of £80 million against Company B’s £150 million.
We can calculate net cash and net debt by taking the company’s total cash and subtracting the total debt. This valuation metric is similar to the book value of a stock, a method popularised by Benjamin Graham (often known as the ‘father of value investing’).
7. Check the company’s Dividend Yield (DY)
So far, we’ve looked at valuation metrics using the company’s earnings, its growth rate, and the value of the company factoring in its cash and debt.
Now we’re going to look at checking the company’s Dividend Yield…
What is the dividend yield?
The dividend yield of a stock tells us what percentage of the stock that we buy we will receive back that year in dividends.
For example, if a stock has a dividend yield of 5%, then we can expect to receive 5% per annum in dividends by owning the equity.
However, it’s no good buying a stock because it has an 8% dividend yield if it is likely to fall 10%!
How to calculate dividend yield
The dividend yield of a stock is calculated by taking the dividend per share and dividing it by the share price.
There is no universally accepted value on dividend yield levels.
However, double-digit dividend yields are often a sign that the market believes the dividend itself is unsustainable, which is why the stock price has fallen so much.
There have been examples where this was not the case of course but it is something to check when buying a stock with a high dividend for income.
Income investors like to buy stocks with steady yields, steady business models, and steady cash flows.
Remember: If the stock price falls then this increases its dividend yield, therefore if income investors thought a double-digit yield was attractive and sustainable they would-be buyers of the stock.
The above steps should be used as a rough guide when valuing stocks.
It is not simply a case of checking a stock’s PEG and then buying all stocks that are growing faster than their earnings ratio. If it was that easy then everyone would be rich.
For example, a company with a low EV compared to its market capitalisation does not necessarily mean the stock is a good buy if management has a history of squandering the cash on value-destroying acquisitions.
And a low P/E ratio is likely no good if the company’s profits are falling!
However, it is best to use these earnings ratios as a quick reference guide and to dig deeper into the company when making investment decisions.
From then, we can look at creating a discounted cash flow analysis which uses a discount rate in order to calculate the future growth and future cash flows of the company.
A discounted cash flow analysis is a stock valuation method that comes up with the value of the stock and a stock’s price that has been discounted back to the present.
We can get all of these ratios from the company’s financial statements, however, it is much easier and quicker to use SharePad to get access to all of a company’s financial statements and its current market price.