The Motley Fool

Investing Basics: How Do You Value a Company? Part I

“Price is what you pay. Value is what you get.”
– Warren Buffett

Investing in stocks is not merely about identifying good companies. Investors must also be able to decipher how much they should be paying for a stake in a company.

In this article, I will highlight three commonly used valuation metrics that can help investors value a stock or REIT.

Price-to-book value

The book value of a company is how much the company is worth if all its assets were to be liquidated, and its liabilities settled. For instance, a REIT that has S$300 million in assets and S$100 million in liabilities, will have a book value of S$200 million.

If the REIT sells all its assets and pays off its creditors, there will still be S$200 million remaining, which could be returned to shareholders.

The price-to-book value (PB) ratio is a comparison of a company’s current stock price versus its book value per share. A company or REIT with a PB ratio below 1 is trading at a discount to its book value. In theory, if the REIT or company chooses to cease operations and liquidate its assets, investors who bought the shares below the book value stand to make a gain.

This is a useful metric for value hunters who are looking to prosper when the market realises the value of a company’s or REIT’s assets, or when the company or REIT eventually decides to cash in on its assets. This sort of valuation method is especially useful for REITs and companies with largely tangible and liquid assets on their balance sheets.

Price-to-earnings ratio

Another commonly used valuation metric is the price-to-earnings (PE) ratio. The PE ratio is a measure of how much you are paying for every dollar in profit earned by the company. It is calculated by dividing a company’s price per share by its earnings per share.

This method of valuation is commonly used for companies that have consistent earnings, or that have predictable growth patterns.

There is no hard and fast rule on what the PE ratio should be. For instance, high growth companies usually command a higher earnings multiple because they have the potential to grow their bottom line fast in the future.

On the flip side, some companies may have lower PE ratios simply because they are not growing as fast, or their balance sheets are not as robust, making them face higher risk of fluctuations in profitability. All these factors come into play when using the PE ratio.

A rule of thumb used by investing legend Peter Lynch to gauge if the PE ratio of a company is reasonable is to take the PE ratio and divide it by the company’s five-year growth rate. This is called the price-earnings growth (PEG) ratio. Lynch recommended seeking out companies that have a PEG ratio of below 1.

Price-to-sales ratio

Finally, the price-to-sales (PS) ratio is used in place of the PE ratio when a company’s earnings are erratic, or the company is making losses. This is useful for a company that is in its early growth stage, when it has inconsistent profits or is experiencing operational losses.

Mathematically, the PS ratio is calculated by dividing a company’s share price by its revenue per share. Again, there is no hard and fast rule on what the PS ratio should be. It depends on how fast a company is growing, and other factors.

In a similar manner to the PE ratio, a high-growth company will likely trade at a higher PS multiple than its slower-growing peers.

The Foolish bottom line

The three metrics shared above are some of the easiest and most commonly used ratios when valuing a stock. There are other valuation methods, such as the discounted cash flow model and the sum-of-the-parts valuation technique. I will be discussing some of the other metrics in my next article on investing basics, so stay tuned!

Worried about the overall state of the market? Do you know the 1 thing you should never do in the stock market? The Motley Fool Singapore’s new e-book lays out a plan to handle market crashes, details the greatest advantage you have as an investor, and looks at decades worth of market data to bring you the smartest insights on investing. You can download the full e-book FREE of charge—Simply click here now to claim your copy.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.