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Valuating Stocks and Industries


Major Methods for Investment Valuation

 

Evaluating Companies and StocksBeen able to evaluate a company true value is very important towards making profitable stock-market investment decisions. In this article, the most important valuating methods are investigated. Here are the five most important valuating methods:

1. Revenue Valuation

2. Earnings Valuation

3. Cash-Flow Valuation

4. Equity Valuation

5. Empirical-based Valuation

  

1) Revenue-Based Valuations (reliability 4/10)


In general, the total revenue of a company is generated by selling goods and services. High revenue of a company indicates a strong competitive position. If you want to compare the revenue of a company to its market value you may use the Price / Sales ratio.

P/S Ratio = Share Price / Sales per Share (annual sales)

Depending on the industry and the company’s growth rate Price to Sales ratio may take values from 0.2 to 10 or even 50. Price to Sales at 0.2 is common for technology stocks which spend heavily on research. From the other hand Price to Sales 50 can be traced to industries with very low growth rate and historically low net profit margins. This method of valuating stocks should be used mainly for newcomers in high-growth industries.


2) Earnings-Based Valuation (reliability 7/10)


Earnings of a company which are also called net profit or net income are very crucial when valuating the company’s fair value. In order to compare different shares –Earning Per Share (EPS) are commonly used. Earnings Per Share for a particular period (usually annually) may be computed by dividing Total Earnings to the total number of shares outstanding:

EPS = Total Earnings for a Period / Total Number of Shares

Now if you want to compare the company’s earning to its stock-market price you may use the P/E ratio. P/E stands for:

P/E = Share Price / Earnings per Share (annual earnings)

The P/E ratio is used in valuating particular stocks, industries and even whole stock-market indexes. The historical average price of the P/E ratio in developing economies stands about P/E=10. That means that investors of a company must wait 10 years to get their money back from the company’s earnings. Companies and industries with high growth potential may be traded at P/E ratio over 20 and sometimes over 50. Companies and industries with zero growth potential may be traded at P/E ratios less than 4. Keep in mind that EPS may sometime describe before-tax earnings and some other time after-tax earnings. The common practice in US and Europe involves the analysis of after-tax earnings. 

 Important Notices:

i) Be aware that sometimes EPS are including forms of one-off earnings that are not going to be repeated in the future. For example a company sells an asset for 100 million dollars while it has spent only 50 million to get it. These 50 million dollars (ex Tax) will be added to its annual earnings –this type of earnings should not be included in your P/E valuation analysis in order to get reliable figures.

ii) High amounts of depreciation may also confuse a P/E ratio valuation model. Companies which invest heavily have the tax privilege of deducting depreciation from its net taxable profits and that cause a company’s P/E ratio to mislead. So normally companies which invest heavily should be traded at P/E ratio above their corresponding industry P/E ratio.


3) Cash Flow-Based Valuation (reliability 9/10)


Cash-flows form one of the most important variables in order to evaluate a company or an industry. Cash-flows are computed in annual basis and can be formed as:

Cash-Flows (for a period) = Cash Inflows – Cash Outflows (for that period)

Based on Cash-Flows, you may use a very common valuating model called Discounted Cash-Flows (DCF). DCF models requires the use of an internal rate of return called IRR but also a forecast of future cash-flows. Based on those two facts an investor can determine with accurrancy a company’s value according to its future cash-flows. DCF is a master valuating method for every professional investment analyst.

Large cash-flows indicate that a company is making real money while it can fund new investment projects without using external lending or issuing new capital. It means also that a company is able to repay its existing debt liabilities and thus avoiding possible future collapse. Cash flows are defined globally as Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). EBITDA is considered more reliable method to evaluate a company’s value than EPS as it avoids accounting conventions that might confuse real cash-flows. Cash flow analysis is commonly used in industries that involve large capital expenditure. In order to valuate a stock based on EBITDA you may use the Enterprise Value / EBITDA ratio

Enterprise Value / EBITDA = Market Capitalization / EBITDA (usually annual)

 

4) Equity-Based Valuation (reliability 4/10)


Shareholder equity incorporates the value of a company's liquid assets. Equity is including cash, hard assets, inventory and also retained earnings. In other words, equity is measuring the value that a company would have today if it was liquidated for any reason. Shareholder equity is evaluated using the Book / Value ratio.

Book / Value Ratio = Shareholder equity / Market Capitalization, where Market Capitalization = Total number of Shares Outstanding X Share Price

Book value is not considered a very reliable method in general and it is used mainly on the Financial and Banking industry where takeovers are often priced based on shareholder’s equity. Equity is really important in banking industry as banks are regulated by Central Banks based on the size of their financial reserves.

Another ratio deriving from the amount of shareholder equity is  return on equity ratio (ROE). Return on equity ratio is measuring how much annual earnings a company has generated given its shareholder equity.

ROE = Annual Earnings / Shareholder Equity

ROE may indicate the management talent and ability to make money given limited organization resources and thus high-ROE companies are historical more attractive to investors that average and low ROE companies.

 

5) Empirical Valuation (reliability 8/10)


Empirical valuation models form a very general field of research. An empirical valuation may arise from unpredictable events. Usually these events affect strongly stock-market volatility. For example after a hostile takeover of a company –investors tend to buy competitive companies in the same industry. If the take over of a company take place at a P/E=20 –it is an important factor of valuation for the rest of companies in the same industry.

Moreover, empirical valuation is widely used in industries which sales are upon customer accounts or subscribers. For example online-services companies, cable TV companies, mobile telecommunications etc. Using an analysis consisting the future expected number of subscribers and their average revenue spending -you may calculate future revenues in relative accuracy. Empirical models can prove very reliable and thus are commonly used by investment professionals.

 

■ Giorgos Protonotarios, for Trading Center

 

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