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What’s the best way to value a company?

Photo credit: Rafael Matsunaga. Licence: http://creativecommons.org/licenses/by/2.0/

Valuing a company is hugely subjective. However, there are means by which it is possible to determine whether a business represents good value for money at its current price level. While no single valuation metric can ever accurately predict the future direction of a share price in every instance, using the following methods could improve the overall performance of a portfolio in the long run.

Price-to-earnings ratio

Perhaps the most common method of valuing a company, the price-to-earnings (P/E) ratio focuses on the income statement. It divides the current share price of a company by its latest annual earnings per share figure. This tells an investor how many years’ worth of profit they are buying, assuming there is no growth in future earnings.

While the P/E ratio is relatively straightforward and simple to use, it can also be an effective means of quickly assessing whether a company’s share price offers fair value for money. Perhaps the best way of doing so is to compare it to historic levels, both for the company in question and for industry rivals. This not only provides a sense of whether it could rise in future, but also whether there is a sufficiently wide margin of safety to merit investment.

Price-to-earnings growth ratio

The P/E ratio’s main limitation is that it is backward-looking and does not take into account the future prospects of a company. For example, many technology companies have high P/E ratios because they are forecast to record high earnings growth in future years. This could make them appear overvalued unless their bottom line prospects are factored in. Likewise, a stock may appear cheap until its deteriorating outlook is accounted for.

In order to combat this weakness, the price-to-earnings growth (PEG) ratio could be a useful tool. It divides the P/E ratio by the forecast growth rate in earnings. Comparing it to industry rivals can be a useful means of assessing whether a company offers good value for money or not, while generally a figure of less than one is viewed as cheap by many investors.

Price-to-book ratio

The price-to-book (P/B) ratio assesses the value of a company’s assets compared to its share price. It is calculated by dividing the market capitalisation of a company by its net asset value. This essentially provides guidance on the goodwill which a company’s current share price includes, since in theory the value of any company is its net asset value plus goodwill for branding, customer loyalty and other competitive advantages.

While the P/B ratio can be useful in industries where assets are an important part of the overall value of a business, it penalises companies which have few assets. Such companies could include consumer goods companies which benefit from significant amounts of customer loyalty. Similarly, asset-light technology companies may also find their P/B ratios are sky-high and unattractive due to much of their value being centred in their future potential, rather than accumulated assets.

Takeaway

In terms of the best valuation method, there is no perfect answer. All three valuation methods discussed above have their strengths and weaknesses. Therefore, it may be prudent for an investor to consider a range of methods, rather than one in isolation. This could ensure that a more balanced view of a company’s worth is achieved, rather than it being penalised for having a fast growth rate or asset-light balance sheet, for example.

Ultimately, valuing a company is highly subjective and stock market valuations can diverge from the mean for long periods. However, by focusing on stocks with relatively low valuations compared to their sector peers and their historic valuations, investors may be able to stack the odds in their favour.

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