“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. Until now, we have learned about:
- Part 1: Getting the right perspective towards stocks investing & the qualities required to become a successful investor,
- Part 2: Different stock picking approaches & the guidelines for selecting the suitable stock picking approach,
- Part 3: The process of shortlisting stocks for detailed analysis & various tools available to an investor for shortlisting of stocks,
- Part 4: The framework of detailed analysis of a company,
- Part 5: Understanding the annual report of a company and
- Part 6: Financial analysis of a company
The current article contains the details of valuation analysis of a company & its stock.
Valuation analysis is conducted to decide whether the stock of a company is current selling at attractive (cheap/undervalued), fair (rightly priced) or expensive (overvalued) valuations. Valuation analysis is second level of filter post financial analysis, used to select stocks for further analysis. Only the stocks that satisfy the criteria of good financial performance and attractive valuations should be analysed further.
Once an investor has found a financially strong company by using the parameters highlighted in Part 6, she should do the valuation analysis to check whether the stock of the company is priced right.
If the shares of a company are overvalued then the investor should avoid investing in it, however good the company’s financial position may be. Investing hard-earned money in overvalued stocks exposes the investor to higher levels of risk where the potential of future appreciation is limited but the risk of losing of money is high. Therefore, valuation analysis becomes paramount before taking a decision to buy any stock.
Valuation analysis compares the stock market values of the stock of a company with its financial parameters. Stock market values consist of current market price (CMP), market capitalization (MCap) etc. Various financial parameters, which are used in valuation analysis, are earning per share (EPS), sales, sales growth rate, earnings (EPS) growth rate, book value, shareholder’s equity, dividend payout etc.
Different investors have devised many criteria to assess the current valuation levels of the stock of a company. Some of these criteria are:
1) PRICE TO EARNINGS RATIO (P/E ratio)
P/E ratio is the most widely used parameter to analyse whether the stock of any company is overvalued or undervalued at any point of time. It is calculated by dividing the current market price (CMP) of a stock by profit/earnings per share (EPS). It represents the price an investor pays to buy INR 1 of earnings of a company.
If P/E is 10, it means that to get INR 1 of earnings in one year from a company, the investor is paying INR 10. Similarly, if P/E is 20, it means that to get INR 1 of earnings in one year from the company, the investor is paying INR 20. If we compare P/E ratio of 10 and 20, in the above example, it would become evident that at P/E of 20, the investor is paying more money to get the same value of INR 1 in earnings than when P/E is 10.
Investors interpret P/E ratio and its derivatives in multiple ways to decide about valuation level of a stock:
- Comparing P/E ratio of the stock with the industry in which the company operates: Industry P/E ratio is the average of P/E ratios of all the companies of the specific industry listed on the stock exchange. If P/E ratio of the stock is higher than the industry P/E ratio, it is assumed to be overvalued and vice versa.
- Comparing current P/E ratio with historical P/E ratio of the stock: if P/E ratio is lower than average P/E ratio of last 10 years, then stock is deemed undervalued and vice versa.
- Comparing P/E ratio with earnings (EPS) growth rate (PEG ratio) as described below and
- Comparing P/E ratio in form of Earnings Yield (EY) with yield on other asset classes like government securities (GSec), Treasury Bills etc. as described below.
Also Read: Hidden Risk of Investing in High P/E Stocks
2) P/E TO GROWTH RATIO (PEG Ratio)
PEG ratio compares the P/E ratio with the growth rate of earnings (EPS) of the company. The underlying assumption is that a stock can command a P/E ratio, which is comparable to the growth rate of the earnings of the company i.e. a company that is growing its earnings at 25% yearly should have a P/E ratio should be about 25.
PEG ratio is measured by dividing P/E ratio with the earnings growth rate (PEG ratio). If P/E ratio is less than the growth rate of the earnings of the company i.e. if PEG ratio is less than 1, the stock is assumed to be undervalued and vice versa.
3) EARNINGS YIELD (EY)
EY takes into account the absolute value of P/E ratio. It is measured as inverse of P/E ratio i.e. E/P. It is calculated by dividing the EPS with CMP. EY provides an idea about the earning/returns that a stock would produce for every INR invested by the buyer in it.
If P/E is 20, then EY would be 1/20 = 5%. Many investors compare EY with Government Securities (GSec) yield in India or Treasury yield in USA. If EY is more than GSec/Treasury yield, then the stock is assumed undervalued and at an attractive investment as investors would find stocks more rewarding than bonds and shift money from bonds/fixed income investments to stocks.
10-year GSec yield in India is currently about 8%. As per above parameter, a stock should have EY of at least equal to 8% (i.e. P/E ratio of 1/8 or 12.5) to be considered a better investment over bonds/GSec.
Margin of Safety (MoS):
The concept of MoS by Benjamin Graham is based on EY. Graham says that the higher the difference between EY and GSec/Treasury Yield, the safer is the stock investment.
To illustrate, suppose the investor buys a stock of company ABC Ltd at INR 100. If EPS of ABC Ltd is INR 10 then P/E ratio would be 10 and the EY would be 1/10 or 10%. As current GSec yield is 8%, ABC Ltd is a good investment. Suppose, after the investor buys ABC stock, its price falls and become INR 50, then the P/E ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy ABC stock as it yields 20% against GSec yield of 8%. This new demand for ABC stock will increase its stock price and limit the downfall. Herein, Graham says that higher the difference between EY and GSec/Treasury yield, higher is the Margin of Safety.
I prefer stocks with P/E ratio of less than 10 as they offer a good margin of safety. Also Read: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing
4) PRICE TO BOOK VALUE RATIO (P/B ratio)
P/B ratio is calculated by dividing the CMP of a stock with the book value (shareholder’s equity + retained earnings) per share. It represents the price an investor pays for INR 1 of the net assets of the company after settling all its outsider’s liabilities.
P/B ratio of 1 means that the investor is paying exactly the money that the assets are in company’s records. P/B ratio of 2 means that one is paying double the amount that the assets are in company’s records. Higher book values mean costlier valuations of the company. Stocks with P/B ratio of less than 1 are considered undervalued and vice versa.
I find P/B ratio irrelevant due to usage of historical cost of company’s assets while calculating the book value. The historical cost might not represent the current market value of company’s assets. However, P/B ratio is very important for companies in financial sector where most of the assets are cash assets and book value is good indicator of net worth of the company.
Benjamin Graham said that an investor should look for companies where P/E * P/B is < 22.5. However, I focus mainly on companies with P/E <10 while ignoring P/B ratio.
5) PRICE TO SALES RATIO (P/S ratio)
P/S ratio was used by James O’Shaughnessy. It is calculated by dividing CMP of a stock with sales per share of the company. It effectively compares the MCap of the company with its annual sales. If P/S ratio of a stock is <1.5, then the stock is considered undervalued. O’Shaughnessy advised investors to sell the stock once its P/S ratio exceeds 3.
6) DIVIDEND YIELD (DY)
DY is a measurement of dividend paid by a stock compared to its market price (DY = dividend paid/CMP). If a company with CMP of INR 100 pays a dividend of INR 2 per share in a year, then its DY is 2%.
An investor can relate DY to rental yield of a residential property or yield on bonds/GSec/Treasury. If annual rental income is INR 2 lac (0.2 million) from a flat, which has a value of INR 1 crore (10 million), then the rental yield of that flat is 2%. High yields, whether dividend or rental, mean that share/flat prices are cheaper and low yields mean that share/flat prices are costlier. Stocks with DY of >5% are considered very attractive.
However, companies that are growing very fast need to invest most of the profits for expansion plans. Such companies prefer to declare very small dividends. I do not focus on the DY, if the company puts the retained profits to good use.
We can find out whether the company is utilizing retained earnings to generate value for shareholders, by comparing the amount of retained earnings with the increase in market capitalization of the company over last 10 years. As per Warren Buffett, a company should generate at least $ 1 in market value for each $ 1 of profits retained. This comparison is an important parameter for assessing the management capability to generate value for shareholders. I would discuss more about it in future article on management analysis of a company.
7) ENTERPRISE VALUE (EV) TO EBITDA RATIO (EV/EBITDA)
Enterprise value (EV) of a company is calculated as Equity + Total Debt – Cash & Equivalents. It is a measure of all the funds employed by a company in its operating assets irrespective of their source i.e. whether own or borrowed funds. We deduct cash & equivalents as they represent the excess assets, which are not deployed in the operations of the company yet. Cash investments provide interest/investment income, which is non-operating income for the company. An individual investor should use market capitalization (MCap) of the company in place of Equity in above formula to arrive at current EV of the company.
EBITDA stands for earnings before interest, tax, depreciation and amortization. EBITDA is a measure of the amount of profits that are pertaining to all stakeholders in the company including shareholders, bondholders or lenders.
EV/EBITDA is a measure of analyzing the valuation level of companies that does not factor in the capital structure (debt to equity ratio) of the company.
Interpretation of EV/EBITDA is similar to P/E ratio. What P/E ratio is for equity holders of a company, EV/EBITDA is for all stakeholders (shareholders, bondholders & lenders put together) of the company. Low EV/EBITDA ratio represents undervalued company and vice versa.
EV/EBITDA is mainly used by investors when they plan to buy entire companies rather than investing in small number of stocks. However, it still has its relevance for equity investors.
In the current article, we learnt about various parameters used for doing valuation analysis of the stock of a company in details. The parameters discussed above are simple ones and should suffice for the basic due diligence by any individual investor.
There are many more ratios like Price to Cash EPS ratio, Cash to Mcap ratio etc, which can be used to gain further insights into the valuation levels of the stock of a company. However, I believe that if an investor analyses any stock on some of the parameters discussed above before she commits to buy it, she would be able to avoid putting her hard-earned money in overvalued stocks where the potential of future appreciation is rather limited and the risk of loss of money is high.
To summarize the important valuation parameters:
- Price to Earnings ratio (P/E ratio): I prefer investing in financially sound companies with P/E ratio of <10. They provide good margin of safety.
- P/E to Growth ratio (PEG ratio): should be <1.
- Earnings Yield (EY): should be greater than long term government bond yields or bank fixed deposit interest rates.
- Price to Book value ratio (P/B ratio): should be <1. However, I find it irrelevant for sectors other than financial services.
- Price to Sales ratio (P/S ratio): buy if P/S ratio is < 1.5 and sell if >3.
- Dividend Yield (DY): Higher the better. DY of >5% is very attractive. However, I do not focus a lot on DY for companies in fast growth phase.
- EV/EBITDA: It is a valuation parameter for entire stakeholders and removes the impact of sources of funds (i.e. capital structure or debt to equity ratio).
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I would like to have your feedback on this series of articles. It would be very helpful if you can tell the readers about the parameters you use for analysis of companies & their stocks.