How To Tell When A Share Is Expensive Or Cheap

We often hear people saying that the shares of certain companies are “cheap” or “expensive”.

More often than not, these people are referring to the share prices of the companies and how much they have risen or fallen compared to a prior period, say six months or a year ago. Seldom do you hear people actually commenting on the valuation of a company to determine if its share price is cheap or expensive. But valuation is actually much more useful and important compared to looking at just a company’s share price. In fact, share prices do not convey much information on their own.

So let’s look at some common valuation metrics and how they can help us point out what’s cheap and what’s expensive.

The ins-and-outs of valuation

A valuation metric can be defined as a method of computing how cheap or expensive the share price of a company is in relation to an important business variable, such as its earnings or cash flow. This valuation metric can then be used to compare companies with similar characteristics within the same industry – this stands in contrast to comparing the share prices of the companies, an action which makes no sense.

Let us start with simple metrics such as the price-to-earnings ratio (PE ratio) and the price-to-book ratio (PB ratio). The PE Ratio is computed by using a company’s share price divided by its earnings per share (EPS). So if a company has a share price of $2.00 and has an EPS of $0.20, then its PE ratio would be 10 ($2 / $0.20). The same method is used to compute the PB ratio, except that the denominator is the net asset value per share (also known as the book value per share) of the company.

What’s cheap and what’s expensive

With these ratios, we can then compare whether companies within the same industry (for example, in banking or in retail) are cheaper or more expensive in relation to one another. If Retailer A has a PE Ratio of 20 while its competitors’ PE ratios average around 10, then Retailer A would be deemed “expensive.” But the analysis should not stop there. Perhaps Retailer A may have certain characteristics or advantages in its business model which make it stand above the rest of the competition, hence giving it a premium valuation. In most cases, the first conclusion would be that Retailer A is more expensive than its peers, and so more research and reading is warranted to find out the reasons why this is so.

The converse could also be true. If Bank A is trading at a PB Ratio of 0.6, while its regional peers are trading at an average of PB Ratio of 1.0, then the investor may consider buying Bank A as it is much cheaper than its competitors. But, Bank A may be cheaper due to company-specific reasons, such as a poor quarter which depresses the ratio. We need to verify the facts and possible reasons for the relatively lower valuation before we invest.

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