The 4 Basic Elements Of Stock Value

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Author: Andrew Beattie

The ancient Greeks proposed earth, fire, water and air as the main building blocks of all matter, and classified all things as a mixture of these elements. Investing has a similar set of four basic elements that investors use to break down a stock’s value. In this article, we will look at the four ratios and what they can tell you about a stock.

 

Earth: The Price-to-Book Ratio (P/B)
Made for glass-half-empty people, the price-to-book (P/B) ratio represents the value of the company if it is torn up and sold today. This is useful to know because many companies in mature industries falter in terms of growth but can still be a good value based on their assets. The book value usually includes equipment, buildings, land and anything else that can be sold, including stock holdings and bonds. With purely financial firms, the book value can fluctuate with the market as these stocks tend to have a portfolio of assets that goes up and down in value. Industrial companies tend to have a book value based more in physical assets, which depreciate year after year according to accounting rules. In either case, a low P/B ratio can protect you – but only if it’s accurate. This means an investor has to look deeper into the actual assets making up the ratio.

Fire: Price-to-Earnings Ratio (P/E)
The price to earnings (P/E) ratio is possibly the most scrutinized of all the ratios. If sudden increases in a stock’s price are the sizzle, then the P/E ratio is the steak. A stock can go up in value without significant earnings increases, but the P/E ratio is what decides if it can stay up. Without earnings to back up the price, a stock will eventually fall back down.

The reason for this is simple: a P/E ratio can be thought of as how long a stock will take to pay back your investment if there is no change in the business. A stock trading at $20 per share with earning of $2 per share has a P/E ratio of 10, which is sometimes seen as meaning that you’ll make your money back in 10 years if nothing changes. The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings. An investor may buy a stock with a P/E ratio of 30 if he or she thinks it will double its earnings every year (shortening the payoff period significantly). If this fails to happen, then the stock will fall back down to a more reasonable P/E ratio. If the stock does manage to double earnings, then it will likely continue to trade at a high P/E ratio. You should only compare P/E ratios between companies in similar industries and markets.

Air: The PEG Ratio
Because the P/E ratio isn’t enough in and of itself, many investors use the price to earnings growth (PEG) ratio. Instead of merely looking at the price and earnings, the PEG ratio incorporates the historical growth rate of the company’s earnings. This ratio also tells you how your stock stacks up against another stock. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings. The lower the value of your PEG ratio, the better the deal you’re getting for the stock’s future estimated earnings.

By comparing two stocks using the PEG, you can see how much you’re paying for growth in each case. A PEG of 1 means you’re breaking even if growth continues as it has in the past. A PEG of 2 means you’re paying twice as much for projected growth when compared to a stock with a PEG of 1. This is speculative because there is no guarantee that growth will continue as it has in the past. The P/E ratio is a snap shot of where a company is and the PEG ratio is a graph plotting where it has been. Armed with this information, an investor has to decide whether it is likely to continue in that direction.

Water: Dividend Yield
It’s always nice to have a back-up when a stock’s growth falters. This is why dividend-paying stocks are attractive to many investors – even when prices drop you get a paycheck. The dividend yield shows how much of a payday you’re getting for your money. By dividing the stock’s annual dividend by the stock’s price, you get a percentage. You can think of that percentage as the interest on your money, with the additional chance at growth through the appreciation of the stock.

Although simple on paper, there are some things to watch for with the dividend yield. Inconsistent dividends or suspended payments in the past mean that the dividend yield can’t be counted on. Like the water element, dividends can ebb and flow, so knowing which way the tide is going – like whether dividend payments have increased year over year – is essential to making the decision to buy. Dividends also vary by industry, with utilities and some banks paying a lot whereas tech firms invest almost all their earnings back into the company to fuel growth.

No Element Stands Alone
P/E, P/B, PEG and dividend yields are too narrowly focused to stand alone as a single measure of a stock. By combining these methods of valuation, you can get a better view of a stock’s worth. Any one of these can be influenced by creative accounting – as can more complex ratios like cash flow. As you add more tools to your valuation methods though, discrepancies get easier to spot. From the Greeks’ four basic elements, we now have more than 100, some of which exist so briefly that we wonder if they count, and none of them are named water, earth, air, or fire. In investing, however, these four main ratios may be overshadowed by thousands of customized metrics, but they will always be useful stepping stones for finding out whether a stock’s worth buying.

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Dapai International Intrinsic Value

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Discounted Cash Flow Model

  • FY2009 Net Operating Cash Flow = S$75.82 Million
  • Discount Rate = 6%
  • Number of Shares Outstanding = 992.3 Million
  • Intrinsic Value
    • Best Case @15% Annual Growth Rate = $1.23
    • Median Case @ 10% Moderate Growth Rate = $0.94
    • Worst Case @ 0% Growth for the next 10 years = $0.56

Discounted EPS Model

  • Rolling EPS = S$0.06459
  • Discount Rate = 6%
  • Intrinsic Value
    • Best Case @15% Annual Growth Rate = $1.04
    • Median Case @ 10% Moderate Growth Rate = $0.80
    • Worst Case @ 0% Growth for the next 10 years = $0.48

 

PE Model

  • Use PE @ 15 as fair value
  • Intrinsic Value = $0.97

 

PEG Ratio

  • Current Price = $0.245
  • Current Rolling PE = 3.79
  • PEG Ratio @ 15% Growth = 0.25 (<< 1) Super Under Value
  • PEG Ratio @ 10% Growth = 0.38 (<< 1) Super Under Value

 

Summary

  • Using MOST CONSERVATIVE Intrinsic Value calculation (ie. 0% Growth for the next 10 years), IV = $0.48 (49% Discount to current price of $0.245)
  • Using a more reasonable 10% Growth Rate for the next 10 years, IV = $0.80 (70% Discount to current price of $0.245)

A potential Multibagger penny stock? You decide……

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How do I value a stock?

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There are 3 different methods of doing a stock valuation.

  • Simple Price / Earning (PE) Ratio & PEG
  • Discounted Cash Flow (DCF)
  • Discounted Earning Per Share (EPS)

Simple PE Ratio & PEG
As a general guideline, a company is at its fair value if the PE is about 15. If the PE ratio less than 15, it is considered under value, and vice versa. I also do a quick comparison of current PE versus the average PE historically. I will pay special attention to the stock price movement if the current PE is more higher than the historical PE average.

PEG refers PE ratio divided by company growth rate. PEG = 1 means that PE growth rate is the same as the company growth rate (measured by either EPS growth rate or net operating cash flow growth rate)

If PEG < 1, the stock price is under value.
If PEG > 1, the stock price is over value.
If PEG = 1, the stock price is at its fair value.

Discounted Cash Flow Model (DCF)
This model is to estimate the company next 10 years net operating cash flow (Future Value, FV) and re-calculate to the Present Value (PV), and add all ten years PV together. The intrinsic value can be calculated after dividing the total number of shares,. The assumption made is the company must be able to generate cash growth consistently with a CAGR (Compounded Annual Growth Rate) which computed from the past history of net operating cash flow.

Net Operating Cash Flow information can be found from the company annual reports, under the Cash Flow Statement.

Discounted Earning Per Share Model (EPS)
Similar to the DCF model, but this time Earning Per Share is being looked into. EPS information can be found at the Income Statement by getting the Net Earning number and divided by the total number of shares. By looking at the historical EPS, a CAGR for EPS growth can be calculated.

By bringing all the 10 years FV of EPS to PV, adding them together give an intrinsic value of the stock.

Valuation of a stocks need some financial background and need some practice. Two key areas to pay attention to:
(1) Where to find the information? All the financial statement can be found from the annual reports by going to the company web site. Another way is to get the summarised information from the website like Shareinvestor (for Singapore Stocks), Morningstar & MSN Money (for US Stocks)
(2) Understand the Financial Fundamental & Definitions like Present Value, Future Value, Discount Rate, CAGR and also practise how to use them. I use the financial calculator to calculate the CAGR and instrinsic value calculator to calculate the intrinsic value of the stocks. I got those simple software (formula in excel form) from my investment course.

I found that DCF model is a better model although it is a little more complicated because Cash Flow is not easily manipulated by the company accountant and cash is always easily be audited. If the company business model is solid, the net operating cash flow grows consistently every year. On the other hand, good EPS numbers do not mean the company is increasing the sales revenue and gaining competitive advantage to expand the market share. EPS can be manipulated easily as the company accountant can add whatever provision they want, using different amortization or depreciation method or using different revenue recognition method. Furthermore, the company can make the EPS more attractive by buying back shares, doing all sorts of cost cutting internally (like selling company fixed assets) to make the number looks nice.

After the intrinsic value is calculated, I compare the current stock price with the intrinsic value. If the current stock price is at least 20% discount to the intrinsic value, I will put the stocks in my watchlist and wait for the right time to buy. I will share in the next post on how I time my entry. 

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