Coming up with an accurate valuation of a stock is one of the key aspects of finding stocks at a bargain. However, because of the vast number of valuation techniques available (often giving different valuation estimates), it may also be one of the most challenging parts of assessing a company. Even seasoned professionals struggle to get this right sometimes. With this in mind, I would like to highlight two of these valuation methods and look at when is the right time to use each of these. This article is also the third part of my series. The first part can…
Coming up with an accurate valuation of a stock is one of the key aspects of finding stocks at a bargain. However, because of the vast number of valuation techniques available (often giving different valuation estimates), it may also be one of the most challenging parts of assessing a company. Even seasoned professionals struggle to get this right sometimes.
With this in mind, I would like to highlight two of these valuation methods and look at when is the right time to use each of these. This article is also the third part of my series. The first part can be found here and the second one here.
Price-to-book (PB) ratio
The price-to-book ratio or PB ratio attempts to value the company based on its book value. The book value of a company is essentially the value of the shareholder’s equity. It can be calculated by deducting a company’s liabilities from its assets. This is also how much shareholders can get back if the company is liquidated.
Therefore, a company that is trading at a discount to its book value is considered cheap considering that shareholders can make a profit if the company decides to liquidate its assets.
The PB ratio is useful for companies that have a high percentage of tangible assets that can be easily sold at market value. For example, REITs and property companies whose book values are largely made up of properties are prime candidates to be valued against their book values. A REIT that is trading at a PB below one can be considered a cheap investment.
On the other hand, companies that have many intangible assets on their balance sheet which cannot be easily sold should not be valued with this method. A business that has a higher return on equity than its peers may also trade at a premium to its book value.
Price-to-sales (PS) ratio
The price-to-sales ratio or PS ratio estimates a company’s worth based on its sales or revenue. This method of valuation is used to compare companies that may not have consistent profits or are at the growth stage of their business cycle.
Take an example of a company that has a share price of $10 and generates $5 worth of revenue per share. The company is therefore said to have a PS ratio of 2. As an investor, to determine if this is reasonable, we need to compare the company’s PS ratio with its peers and its historical trading price.
Take note that there are many factors that you should consider when determining what a reasonable PS ratio for a company is. For instance, a company with a higher growth potential should be valued at a premium to its peers. Other qualitative factors of the company also play a part in its valuation.
This method of valuation should be used in companies that have lumpy earnings or are growing. For example, e-commerce companies that are growing at a breakneck pace at the expense of profits should be valued with this method.
The Foolish bottom line
These two valuation methods are two of the most commonly used valuation methods. They are both simple to calculate as both sales and book value are easily obtained from the financial statements of a company. These figures can also be taken raw and are not as easily manipulated the way profits can be through various accounting practices.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.