Comparative Valuation Gets Stock Investor Started on Track of Correct Price
One of the most difficult questions investors have to answer is how much should they pay for a stock. This rather simple question is much more difficult to answer the many people might expect.
Unfortunately, many investors answer the question by saying what is it trading for now? That's absolutely wrong answer and the wrong way to decide what to pay for stock.
Putting a value on a stock can be a very complex process and in later articles will look at how that works.
However, there are some quick and dirty ways to get an idea about whether a stock is underpriced or overpriced without raising too much of a mental sweat.
We have been looking at for companies to use in our examples and their key numbers are listed at the bottom of this article. I have a target company and three other companies that are in the same industry and are about the same size as our target. These are real companies and these are real numbers, but since this article may be on the web for some time I'm not using the company names because much can change over time.
One of the ways you can arrive in the valuation of the company is by comparing it to his peers, which is what these four companies represent. It is very important that you find companies that are true peers of your target company and not just in the same industry. This may take a little work, but MorningStar will help you by suggesting peers of your target company.
One of the most common ways to do a relative valuation involves using the price to earnings ratio or P/E to compare the four companies.
If you look at the companies listed in this article you'll notice that the three peer companies all have a P/E that ranges from 9.1 to 9.7, while the target company has a P/E 14. This higher P/E tells you that investors are willing to pay more for the earnings the target company generates then they are for the three peer companies. It doesn't tell you if the market is correct about the price.
Based on a comparison with its peers, the target company seems overpriced. If you average the P/Es for the three peer companies, it comes out to around 9.4.
Now, take the P/E formula and do a little math, after getting one metric I did not include - the company's earnings per share, which in this case is 2.51.
P/E=stock price/eps
9.4=stock price/2.51
stock price=9.4 x 2.51
stock price = $23.29 per share
This rough example tells us that, based on comparable companies, our target may be overpriced. If we apply the average P/E of the comparable companies and use it to determine what our target company's price would be if it had a comparable P/E, we see that its price is quite a bit above what it is trading at: $35.23 per share.
This method of valuation is simple and often wrong in the details. Here are some of the problems:
This method really just gets you started and is not a final determination. You need to look more carefully at any company that looks like a candidate based on this method.
Company 1
Market Cap $17.9 B
Price: $52.81 per share
P/E 9.5
P/B 2.2
P/S .8
P/CF 8.9
Company 2
Market Cap $15.5 B
Price: $61.52 per share
P/E 9.1
P/B 1.5
P/S .7
P/CF 8.2
Company 3
Market Cap $16.7 B
Price: $49.79 per share
P/E 9.7
P/B 2.2
P/S 1.1
P/CF 13.7
Target Company
Market Cap $16.3 B
Price: $35.23 per share
P/E 14
P/B 2.7 (book value per share: 12.88)
P/S 1.2 (revenues: 13.4 billion)
P/CF 6.7 (cash flow per share: 5.56)
Here are the metrics I am using for this model:
Market Cap: outstanding shares x market price
P/E (price to earnings): stock price / earnings per share
P/B (price to book value): share price / book value per share
P/S (price to sales): market cap / revenues
P/CF (price to cash flow): share price / cash flow per share
Unfortunately, many investors answer the question by saying what is it trading for now? That's absolutely wrong answer and the wrong way to decide what to pay for stock.
Putting a value on a stock can be a very complex process and in later articles will look at how that works.
However, there are some quick and dirty ways to get an idea about whether a stock is underpriced or overpriced without raising too much of a mental sweat.
We have been looking at for companies to use in our examples and their key numbers are listed at the bottom of this article. I have a target company and three other companies that are in the same industry and are about the same size as our target. These are real companies and these are real numbers, but since this article may be on the web for some time I'm not using the company names because much can change over time.
One of the ways you can arrive in the valuation of the company is by comparing it to his peers, which is what these four companies represent. It is very important that you find companies that are true peers of your target company and not just in the same industry. This may take a little work, but MorningStar will help you by suggesting peers of your target company.
One of the most common ways to do a relative valuation involves using the price to earnings ratio or P/E to compare the four companies.
If you look at the companies listed in this article you'll notice that the three peer companies all have a P/E that ranges from 9.1 to 9.7, while the target company has a P/E 14. This higher P/E tells you that investors are willing to pay more for the earnings the target company generates then they are for the three peer companies. It doesn't tell you if the market is correct about the price.
Based on a comparison with its peers, the target company seems overpriced. If you average the P/Es for the three peer companies, it comes out to around 9.4.
Now, take the P/E formula and do a little math, after getting one metric I did not include - the company's earnings per share, which in this case is 2.51.
P/E=stock price/eps
9.4=stock price/2.51
stock price=9.4 x 2.51
stock price = $23.29 per share
This rough example tells us that, based on comparable companies, our target may be overpriced. If we apply the average P/E of the comparable companies and use it to determine what our target company's price would be if it had a comparable P/E, we see that its price is quite a bit above what it is trading at: $35.23 per share.
Big Warning!
This method of valuation is simple and often wrong in the details. Here are some of the problems:
- The method depends on the market pricing the comparable companies correctly. If one or more comparable companies is over or under priced it can change the results.
- Unusual market activity can skew results.
- Method does not explain why a stock appears under or over priced.
- Method says nothing about the future value of the stock/company.
This method really just gets you started and is not a final determination. You need to look more carefully at any company that looks like a candidate based on this method.
- Does it have an economic advantage (economic moat)?
- Is it in a growth industry?
- What are the risks facing the industry/company?
- And much more
Company 1
Market Cap $17.9 B
Price: $52.81 per share
P/E 9.5
P/B 2.2
P/S .8
P/CF 8.9
Company 2
Market Cap $15.5 B
Price: $61.52 per share
P/E 9.1
P/B 1.5
P/S .7
P/CF 8.2
Company 3
Market Cap $16.7 B
Price: $49.79 per share
P/E 9.7
P/B 2.2
P/S 1.1
P/CF 13.7
Target Company
Market Cap $16.3 B
Price: $35.23 per share
P/E 14
P/B 2.7 (book value per share: 12.88)
P/S 1.2 (revenues: 13.4 billion)
P/CF 6.7 (cash flow per share: 5.56)
Here are the metrics I am using for this model:
Market Cap: outstanding shares x market price
P/E (price to earnings): stock price / earnings per share
P/B (price to book value): share price / book value per share
P/S (price to sales): market cap / revenues
P/CF (price to cash flow): share price / cash flow per share
Source...