The Best Way to Value a Stock: Part II

Choosing the correct valuation method is vital in estimating the true worth of a business. Unfortunately, that is simpler said than done. With so many valuation methods available, and each often leading to very different conclusions, investors often have difficulty assessing how much they should reasonably pay for a stock.

To simplify things, I have decided to summarise some of the more common valuation methods and discuss when each should be used in a series of articles. The first article of the series can be found here. In this article, I will talk about the price-to-earnings ratio and the price-to-earnings-to-growth ratio.

Price-to-earnings (PE) ratio

This method of valuation attempts to value a stock based on its earnings. It can either be calculated historically, based on past earnings or by using forward earnings estimate.

For example, a company has $1 million in earnings in the past 12 months. If you believe that the company should be worth 10 times its earnings (in other words have a PE ratio of 10), then the company should be worth around $10 million. Investors can then assess whether the company is trading below or above $10 million to determine if the stock is worth its price.

To come up with a reasonable PE ratio for a specific company, investors need to take into account a few factors.

First, it is important to look at the past PE ratios of the company. If, for instance, a company has consistently traded at a PE ratio of 20, then that might be the fair multiple based on other investors’ sentiments.

Investors also need to take note of the company’s growth potential. A company with a higher earnings growth potential should in turn trade at a higher PE multiple. Other qualitative factors like strength of management, balance sheet and quality of their business should also be a factor in whether the company deserves a higher PE multiple. The company’s PE multiple also needs to be considered relative to its peers.

As with each valuation method, the PE ratio has its limitation. As you may have inferred, the PE ratio is only useful for companies that have consistently made a profit. It is not as useful for companies with lumpy earnings or whose earnings are cyclical in nature.

PE-to-growth (PEG) ratio

The PE-to-growth (PEG) ratio, made popular by Peter Lynch, goes one step further and takes into account both the PE ratio and growth prospects of the business. It is easily calculated by dividing PE ratio with the growth of the company. Once again, a lower PEG ratio is indicative that the company is relatively cheaper.

For example Company A has a PE ratio of 20 and growth of 50% per year. The PEG ratio is therefore 0.4. Company B, on the other hand, has a PE ratio of 10 and growth prospects of 5% a year. The PEG of company B is 2. In this scenario, company A will be considered cheaper than company B using the PEG ratio.

Just like the PE ratio, investors need to take note of other factors when assigning what a reasonable PEG ratio a company should have.

This method is useful in comparing companies that have easily forecasted growth rates and earnings. On the flipside, do not attempt to use the PEG ratio for companies that have volatile earnings or their profits cannot be easily forecasted. In such cases, using a wrong estimate to calculate the PEG ratio can result in an inaccurate valuation.

The Foolish bottom line

The two valuation methods described above are both essential tools for any investor. They are simple to calculate and can be used to compare companies with similar characteristics. The next article, I will feature the price-to-book ratio and the price-to-sales ratio.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.