There is a common saying “Good companies may not always be good investments”. Even if you have done in-depth fundamental analyses and identified a good company with sound business, strong management, long-term growth prospect, good profitability and solid financial strength, buying at excessive valuation could still lead to severe loss. Valuation is of crucial importance to successful investing.
Price to earnings ratio
Price to earnings (P/E) is a widely known and popular valuation tool used by investors. It is calculated by dividing a company’s share price by its earnings per share in a year. So if the share price is $10 and earnings per share is $1, the P/E ratio of that stock would be 10. It helps provide a quick comparison for determining whether a stock is cheap or expensive as it measures how long it would take, in years, for the company to earn sufficient money to justify its current valuation. Assuming profits remain the same, a P/E ratio of 10 indicates a ten-year cost recovery. There are two types of P/E ratio, namely trailing P/E and forward P/E. The former one is based on the most recent reported one-year earnings of a company, whilst the latter one refers to the forecasted earnings (one or two years ahead) by analysts. It appears that a company traded at a trailing P/E of 30 is somewhat expensive, but its forward P/E may be as low as 15 if earnings is expected to double over the next year. While the forward P/E ratio takes into account the prospect and earnings growth of a company, we should be mindful of analysts’ aggressive assumption of earnings forecast.
Relative valuation and historical comparison
There is no absolute answer as to what P/E ratio should be, so that we can conclude whether it is high or low. What constitute reasonable ratios also vary from sector to sector. For instance, P/E ratios of high growth technology companies may reach 20 or above, whereas public utilities with stable earnings normally trade at much lower P/Es. It is not right to simply compare the two P/E ratios to say one of them is undervalued because of the difference in business nature. A better way is through comparison in the same industry or with key competitors. Given their comparable business and size, we can compare P/Es among peers and industry average and further determine the value of a company in relation to that of others. This is known as relative valuation approach. Another way is looking into historical P/E over the past ten or twenty years and figuring out where the current P/E stands along the long term trend. If it deviates from the average by one or two standard deviation, one should note that the market may be overly optimistic or pessimistic in valuation and should beware of mean reversion over time.
Do not rely on just one gauge
Investors should look at a broad range of valuation metrics and financial ratios, in order to form a more comprehensive view of any company. Besides P/E, there are a variety of valuation measures, including price to sales, price to book and price to cash flow, and various profitability margins such as gross profit margin, operating profit margin and net profit margin. The level of return on equity and return on capital employed are key measures to give an indication of the efficiency of the management. It is equally important to look into debt to equity ratio and cash flow to net financial costs, which specifically indicate the strength of a company’s financials.
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