July 22, 2011 PSW Staff
as to what the stock could, should or would be worth after looking at all of the different
valuation methods and techniques that could possibly exist. The other type is found
by typing the stocks ticker symbol into a financial website, seeing what the last quoted
price was and then knowing what it is actually valued at in real-time. Yes the second
type is a lot simpler than the first, but do not get too excited just yet. Neither type could
exist without the other one, and unfortunately if you want to make any money buying
and selling stocks, you will have to learn how to use both.
The actual valuation of a stock in real-time is calculated by simple supply and
demand. It is found by looking at the last actual sale of stock that has occurred based
on a simple auction method. Multiplying the share price by the number of shares the
company has outstanding will give you the total value, or market capitalization of the
company. Since this is completely straight forward and simple, we will focus on the
other type of stock valuation for this article, the educated guess type. Just keep in
mind that many of the methods for calculating an educated guess are derived from
the actual real-time supply and demand price, so it is important to not only know
where the stock is now, but where it has been in the past.
What is the point of forming an educated guess as to what you think the stock should,
could or would be worth? Whether you call it fair value, intrinsic value, fundamental
value or something else, the point is that you are looking for a number that is
separate from the current price. Once you determine this number, you can compare it
to the current price and decide whether the stock is undervalued, overvalued, or
valued just right. Analysis should not end here, however, you also need to determine
if the stock is under or overvalued for a reason, or for no reason at all. One way to
gain tremendous insight into this dilemma is to look at historical valuations of the
stock, not just current ones. You will also want to look at current and historical
valuations of closely related stocks, stocks in the same sector, stocks of similar size,
and even all stocks in general.
If you are reading this article, there’s a pretty good chance that you've heard of P/E or
the price to earnings ratio. This is without a doubt the most popular valuation
measure. EPS or earnings per share is the ultimate bottom line with respect to how
well a company is doing. We can look at the current P/E, which is the current price
divided by the trailing twelve month earnings, and we can say the lower the P/E is, the
cheaper the stock is. We can also look at forward P/E by taking the current price, and
dividing it by forcasted earnings for the next year or two years. We can also take the
P/E and divide it by forecasted earnings percentage growth, which is known as the
PEG ratio. Typically, a PEG of 1 is considered fair value.
If you are interested in lower priced stocks, as we are, you probably know that
earnings are not quite as abundant as the stock price gets lower. This means that
we have to look at more creative ways to value the stocks that we are interested in.
This is where we believe an advantage exists for small and micro cap stock traders
who become adept at valuing shares. Without as many cut and dry valuation ratios to
go by, stock prices in this arena tend to become more and more inefficient, therefore,
issues can become grossly under or overvalued.
There are tons of ratios and measures to look at, all of which are derived from either
the income statement, balance sheet or cash flow statements. Many of these
numbers are divided by the stock price or the number of shares outstanding or both to
give us a per share figure that is easier to contemplate. You'll be able to find a ton of
ratios to ponder just by looking around at financial websites a little bit, and a lot of
them are self-explanatory. We'll take a look at a couple you may not have thought
about, but keep in mind that the more ratios you look at, the better. Even if you feel
confused by the end of your exhaustive research, we guarantee that you will be able to
come up with a much more efficient guess than those who only look at P/E's.
Price to Sales or P/S compares the current stock price to trailing twelve month top line
revenues. This number will vary a lot more than P/E will among different stocks.
Keep in mind that the sales part of the equation is calculated on a per share basis,
therefore, the less shares there are outstanding, and the more revenues the company
has, the better, or lower, the number will be.
Enterprise value is a better way to value the company as a whole than just looking at
the market cap. When a company is taken over, the buyer has to take on the
company's debts, but gets to pocket the cash, and enterprise value is a good
approximation of what a suitor would have to pay. EV is calculated by taking the
market cap and adding all of the short and long term debt, as well as accounts
payable. Then you subtract the cash and cash equivalents, as well as accounts
EBITDA or earnings before interest, taxes, depreciation and amortization is a pretty
good earnings normalizer. Keep in mind that most financial firms calculate EPS, P/E
and PEG with non-GAAP, or pro forma numbers. These are earnings before one time
items etc.(see our article GAAP vs. non-GAAP) and can be less normalized than
EBITDA. If you really want to get fancy, a great valuation measure to look at is
Enterprise Value to EBITDA and be sure to compare it with other companies.
Don't forget to look at all of the balance sheet ratios, like book value, price to book
value, price to cash and so on. This is a good way to find stocks that may be
undervalued if you have a longer time frame to work with. Has the stock had low
balance sheet valuations for a long time? If so, it may be a very safe and boring
issue. Have they suddenly become low? Something on the earnings or revenue front
may be the culprit. Always be aware that ratios that are just too low are almost always
a bad sign. Once again, the take away here should be that the more dimensions of
stock valuations you can see, hear, smell, taste and touch, the more likely you are to
make a good decision.
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