The Science of Valuation

As an investor (or a trader) you will have a specific interest in valuing a stock to help ascertain the growth potential. For example, is "XYZ" bank better 'value' than its peers?

Investors are traditionally willing to pay a premium price for companies consistently posting above-average growth and the ability to identify stocks that are undervalued would allow you to buy at a time that would maximise your gains.

There are a number of standard valuation tools that can be used to assist you in reaching a decision. Assuming that all calculations are standardised for all peer group comparisons, these valuation tools can provide credible indications of investment or trading opportunities. They are all based around comparing the current share price to other numbers that can normally be found in the corporate accounts; Earnings, dividend, assets and sales.

The Price/Earnings (P/E) ratio.

Also referred to as the earnings multiple of the company. This is probably the best-known, and most quoted measure of valuation. Calculated as the price per share divided by the amount of earnings per share (net profit after tax) over the preceding 12 months, it is the number of years it will take to recover the purchase price from earnings at the current rate. The accepted theory is that if you can buy a company for 5 times its earnings, it has a better chance of increasing in value than where you pay 15 times its earnings. As always there are exceptions such as a company that has good growth prospects. It can therefore justify a higher ratio due to the earnings growing quickly (this can be verified by using the other valuation tools below). However, the 'tech wreck' period showed us that the PE ratio for a growth company can also be too high with expected growth already factored into the price with little leeway for error.

Dividend payout ratio

This is a means of measuring the sustainability of dividend payments. By calculating the proportion of company profits that are paid out as dividends (dividends per share divided by earnings per share). Therefore if a company is earning $5 per share, and pays a dividend of $4 per share, the payout ratio is 80 per cent.

The Price/Assets ratio.

This tool is typically used when investors are seeking value stocks. Value stocks are those that typically sell with relatively low price/assets ratios which imply that their market value is close to their asset value and that their intangible assets (Structure, staff, management, goodwill etc) are valued at a low level. One would expect that the intangible assets could provide an increase in value; e.g. the appointment of a Managing Director with a successful track record.

The Price/Sales ratio.

A tool that can assist in measuring a companies potential, particularly useful when trying to value companies that currently do not have earnings or are experiencing operating difficulties and are reporting depressed earnings.