In a previous article, I discussed various valuation metrics and how these would affect one’s investments. Let’s drill down a little deeper now and look into exactly how we would determine if shares are cheap or expensive.
My previous article referred to the terms “cheap” and “expensive” in relation to the valuation of each company, and not just by looking at the absolute share price. Hence, a company trading at $10 may be cheap if it offers good earnings and cash flow potential in the future, while one trading at $0.10 may be expensive if it continually burns cash and is in danger of going bust. Usually, however, most companies do trade at a level which indicates they are “fairly valued”, which means it is neither cheap nor expensive. So what methods can investors use to determine if something is too expensive for comfort, or if it is “just right”?
Firstly, let me reiterate that valuation is a subjective exercise, though we can base the analysis on hard numbers which are quantifiable. This is because most of the time, we are looking at valuations using the rear-view mirror, and the future is always murky. Therefore, we can at best make an educated guess as to whether a company is too expensive, or not.
One method an investor could use is to compare the company’s price-earnings ratio to its five-year average. If it is trading much higher than its five-year average, this could signal that investors as a whole are very optimistic about its prospects and that its shares may not be cheap. Some investors may wish to go back even longer and use the 10-year average, which may be more robust as it would usually include an entire business cycle.
The second indicator an investor can use is industry absolute valuations. Every industry has its unique characteristics, and there will be an average valuation range which most companies trade at within the industry. As an example, most pharmaceutical and healthcare companies trade at multiples of 25-30x price-earnings, and this is considered the “normal” range. If a company within this industry trades at say, 50x earnings, then it may be perceived as being much more expensive, and the investor may want to dig further to find out why or avoid it.
The next article on valuations shall drill down further into common metrics used by investors such as the price-earnings ratio and dividend yield, amongst others.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.