Technical Indicator Wisdom 5
Next step is to find support and resistance levels.
Five Basic Ratios
While there are many ratios that can be used to value a stock, the following four sets are the most used in analysis to determine the fair value of a stock.
Ratio 1: The Price-to-Book Ratio (P:B)
The simple explanation of this ratio is to take the breakup value of the company (valued per share) and compare it to the share price.
You find that corporate raiders often use this ratio to determine whether a hostile takeover is worthwhile. In addition, these analysts would revalue the equipment, buildings, land, and machinery to determine a fair value for the company. So, if the recalculated value is $100 million and the company has 50 million shares in issue, the breakup value (P:B) would be $2 or a ratio of two times. If the stock price is $1.50, then the corporate raider or trader, for that matter, will gain 25 cents per transaction.
Industrial and mining companies tend to have a higher book value, as these are based and valued on more in physical assets. Therefore, a low P:B ratio can protect traders as this means that there is little or no difference between assets and stock price.
Ratio 2: Price-to-Earnings Ratio (P:E)
The price to earnings (P:E) ratio is certainly the most used of all the ratios. It can be expressed as the amount of years that a company takes to achieve in net profits per share what you are willing to pay for the stock. So, if the P:E ratio is five times, it means that it will take the company 5 years to equal EPS. An example would be a share price of 100 cents and an EPS of 20 cents (100 ÷ 20 = 5).
Remember that the stock market is forward thinking, so a high P:E ratio may indicate that the market expects the company to have increased revenues per share. In addition, traders should only compare P:E ratios between companies in the same index, that is similar industries and markets.
These factors are discussed later in these volumes.
Ratio 3: The PEG Ratio
Many analysts believe that the P:E ratio isn’t adequate as a valuation tool, so they combine it with earnings growth to create the PEG ratio, thus this ratio uses the historical growth rate of the company’s earnings in addition to earnings.
The calculation is simply to take the P:E ratio and to divide it by the EPS growth rate. The lower the PEG ratio, the higher the potential for the stock achieving its future-forecasted earnings.
PEG Ratio Calculation |
Explanation |
= 1 |
The stock is expected to break even if the company’s earnings growth doesn’t increase above its historic average. |
= 2 |
Projected growth is twice that of a stock with a PEG of 1. |
My issue is that this ratio is speculative as there is never any guarantee that historic earnings growth will continue.
The conclusion is that the P:E ratio is an overview of investor sentiment toward a company and the PEG ratio tells you where the investor sentiment has been. This information effectively tells traders whether investor sentiment is likely to stay unchanged or change for the better or worse.
Ratio 4: Cash Flow Per Share and Free Cash Flow
Cash Flow Per Share
Cash Flow Per Share = (Operating Cash Flow – Preferred Dividends) ÷ Ordinary Shares Outstanding
This ratio is often used as the final check on an investment or trading opportunity, as it places a greater focus on the cash-flow-per-share value than on EPS. While an EPS value can be easily manipulated via an added income or deduction in the income statement, cash flow per share is more difficult to alter.
Calculated as a ratio, cash flow per share indicates the amount of cash a business generates before accounting for depreciation and amortization as these variables deflate the amount of actual cash in the company’s books.
It must be noted that a company with a higher cash flow per share than its share price means that the share is trading at a discount to fair value and at a premium if the cash flow per share is lower than its share price.
Free Cash Flow
Free cash flow effectively adds back any figure which artificially reduces cash holdings, such as arbitrary or once-off capital expenses and dividend payments. The aim is to calculate the exact amount of cash generated by the company.
Ratio 5: Dividend Yield
Dividend Yield = (Dividend Per Share ÷ Share Price) × 100
The dividend yield tells traders how much dividends they will get paid out as a percentage of earnings. It is not based on share prices, but on the number of shares held in a portfolio.
Therefore, if a company pays out a dividend of 100 cents and you hold 100 shares, you will receive $100 in dividends, whatever the share price is.
Note that, while a fall in share price doesn’t determine how much dividend income you will receive, it must be noted that a lower share price may cause a company to not declare a dividend that year.
Some Valuation Warnings
Heed the following valuation warnings.
Price:Earnings Ratio (P:E Ratio)
• The use of PE ratios to determine the value of future investment sentiment is inaccurate, as it assumes many companies have similar future earnings growth prospects. Analysts talk of forward PE ratios being expensive or cheap, in reality this is an anomaly and simply confuses traders.
• For instance, a PE is calculated by dividing the share price of a company by its EPS. If the EPS is forecasted as positive, then the PE must fall. If the EPS is forecasted to be lower, then you wouldn’t invest in such a company anyway.
• To avoid this problem, find the average three year PE and compare that number to the current PE. Investor sentiment usually returns to its norm.
• For instance, if the current PE is 10 times and the historic three year PE is 12 times, you can assume that the company is currently expensive, based on a potential fall in investor sentiment during the next trading period.
Net Asset or Book Value
Another valuation technique that is misunderstood in its proper application is the net asset or book value of a company. Effectively, if the sum of the parts of a company calculated per share is higher than the share price, then the share price is at a discount to book value.
The problem arises when analysts take the value of the assets owned by the firm straight from the company financials. These values often are not realistic as property and other fixed assets are not revalued every year. To be effective, you need to conduct a simple recalculation of the land owned by the company and so on.
An exception is when the assets of a company are overwhelmingly listed shares in one of its divisions, which may also be listed. These two-tier pyramid structures often result in a discount or premium, which often remains in place until the two structures are collapsed into a single unit.
The Bottom Line
The above valuation methods should be used together and not in isolation. By combining these, traders can better understand the factors influencing current and future share values.
These three volumes will highlight additional valuation techniques, which will enable you to calculate fair value, identify pitfalls and future prospects.
Chapter 6 forms the basis of establishing share trading rules.