Every time you choose to buy or sell a share you take a view on what the share is worth, and whether the market's valuation is high, low, or about right.
We are going to take a look at valuing shares as an explicit, practical discipline. We will first run through the basic methods, and then have a look at how they can be applied in practice on companies in various sectors.
Valuation methods tend to focus on numbers, but they need to be considered in the context of the company's prospects, and the risks in its business.
Two Main Approaches
There are two main approaches:
Relative valuation – how does the company's share price compare with other companies in the same sector, or the market as a whole?
Future income - by forecasting the future profits, cash flow, dividends or other economic factors of the company.
How Much Time Have You Got?
If investing is your day job, then you have the time to build comprehensive financial models and make sensible forecasts from which discounted cash flow valuations can be derived. That is what a stockbroker's analyst, covering a handful of companies all in the same sector, will do.
But the amount of time and effort required to use DCF and other forecasting methods means that they are not very often practical tools for the individual investor.
The Relative Valuation Approach
So I am a fan of the relative valuation approach -- and not just for basic share valuation metrics such as P/E ratio and dividend yield. It is very instructive, when researching a company, to look at one or more other companies in the same sector. Apart from the numbers, the most useful things to compare include:
* Business mix and geographical coverage;
* The business model and strategy; and
* What the management says about trading conditions and prospects.
If you only look at one comparative company, choose a large, well-researched one which makes some effort, in its accounts and/or on its website, to explain its strategy and the important trends and developments in its industry.
There is one important area in which private investors can benefit from the analysts' financial models. Consensus forecasts of revenues, earnings and dividends are widely available for most stocks. These are averages of the forecasts of all the analysts covering a stock, and as companies give "guidance" about their prospects, forecasts for the next year end are based on more than just idle speculation.
So where possible I would usually use the prospective P/E ratio and dividend yield (based on the forecast for earnings and dividend for the next year end) in comparing companies.
Putting all this together, my approach is:
1. Choose one or more comparator companies.
2. Learn about the sector, and how the business and strategy of the company compares with others in the sector. From this you can form a view as to the prospects and downside risks for the company.
3. Compare the basic valuation measures: prospective (or historic) PE, dividend yield, PEG ratio etc. This is a good time to look at analysts' recommendations.
4. If the basic valuation measures do not make sense, then look at other valuation measures such as price/sales or price/book value.
5. Look at how the share price has performed over the past twelve months (or longer).
6. Examine and compare the operating performance: revenues, margins, return on capital etc.
7. Examine and compare the financial strength: gearing, dividend cover, cash flow, tangible assets etc.
8. Look for any hidden liabilities or value, e.g. pension fund deficits, over- or under-valued properties.
A Comparison Table
Drawing up a table such as the one below is a quick and easy process which helps focus attention on what may be driving the market's valuation of a share:
All of the numbers can be taken from the CSE Company Financial Info, with just a little bit of arithmetic required for the revenue growth and cash flow ratios.