There are several ways in which a stock’s valuation can be calculated, and this is primarily through the use of differing price ratio methods.
Higher priced or “hot stocks” and the overall market have not been able to compete with value stocks when it comes to returns in the long run. According to the Brandes Institute, value stocks can be described as those whose share price is at a level which is lower to its overall performance from the viewpoint of earnings, sales and dividends. In short, they are seen to be available to purchase at a discounted rate whereby the current stock price is simply lower than it “should” be – i.e. an undervalued stock
In comparison, the prices of these “hot stocks” or “glamour stocks” tend to be inflated by the narrative surrounding the company as opposed to just the fundamentals, which should be the main focus. In this case what tends to happen is that many investors enter a buying frenzy because they do not want to miss out on the opportunity, especially if there has been a recent surge in the stock price
According to the Financial Times, it is value stocks which were able to help investors weather the proverbial market storm in the first few months of 2022, with Vanguard projecting that over the next 10 years value stocks in the US markets will deliver annualized returns of 4.1%, whereas growth stocks will deliver only 0.1%.
Different investors and financial experts use their preferred methods of valuing a given stock, however there are certain valuation methods, which are overall more popular than others.
Types of Price Ratios
Price to Earnings (P/E) Ratio
This is considered to be one of the most popular ways to value a company. The P/E ratio is calculated by dividing the current share price by a company’s earnings per share (EPS), usually for the last financial year. The resulting figure gives an indication of how much an investor will pay for each $1 of total earnings.
P/E Ratio = Share Price/EPS
This can be further broken down into a trailing P/E ratio, which takes into account the previous few quarters, or a future P/E which takes into account the earnings of upcoming quarters.
A high P/E ratio suggests that an investor is paying more per share than the company is earning. This is common with technology companies and other new businesses where a high level of capital is needed to get the company off the ground.
For example, a company which has 1 billion shares outstanding with earnings of $1 billion would result in an EPS of $1. With a stock price of $75, the ratio would be calculated by dividing the stock price by EPS resulting in a P/E ratio of 75. This would be considered very high, however depending on the industry and company’s specific business model it wouldn’t necessarily be a sure sign that the valuation is inflated.
This ratio takes into account market capitalization as well as the value of the total liabilities if the whole business in question were to be acquired.
The result is what is known as the total enterprise value (TEV), which also uses EBITDA (earnings before interest, depreciation and amortization) as part of the methodology.
This is calculated by dividing the EBITDA by the Total Enterprise Value (which is the market capitalization + total debt – excess cash + preferred stock + minority interests).
Enterprise Yield = EBITDA/TEV
An example of this would be Tesla Inc.
Currently Tesla’s TEV value is approximately $835.46 billion, with the EBITDA standing at $12.702 billion.
This would give Tesla an Enterprise Yield Value of 1.52%.
As we’ve seen the most commonly used Price to Earnings Ratio (P/E) is calculated by dividing the price of a stock by the earnings, however if this formula were to be inverted the result would be the earnings yield. This is calculated by dividing the Earnings Per Share (EPS) by the Price per Share.
Earnings Yield = EPS/Price per Share
Gross Profits Yield
This calculation gives a guideline of the amount of profit that is returned to the stock once the COGS (cost of goods sold) figure is subtracted from total sales.
Gross Profit is calculated as Revenue or Total Sales – COGS
Therefore the Gross Profit Yield is calculated as follows:
Gross Profit Yield = Gross Profit/Total Enterprise Value
Free Cash Flow Yield
The Free cash flow yield percentages give an indication of the free cash flow per individual company share it is expected to again against the market value of each share. This is a particularly good indicator for investors as it gives an insight into the company’s position regarding liquidity in case of an emergency or unforeseen circumstance in the operation of the company.
It is calculated as follows:
Free Cash Flow Yield = Free Cash Flow per Share / Market Price per Share
In summary, the higher the yield percentage, the better the investment in that particular company. This is due to a lower yield meaning that for every dollar invested in the company the return is not particularly healthy. A high yield percentage suggests that there is enough income being generated by a company in order to meet its debt return requirements and other financial commitments, which includes the paying out of dividends to its shareholders.
Book to Market Ratio
The Book to Market Ratio is helpful in ascertaining whether a company is seen to be fair value, undervalued or overvalued. As a general rule, a book value which is higher than the market value suggests a company is undervalued, and if the total market value of the company is sitting at a figure higher than its book value per share, then it is seen to be overvalued. This calculation works by comparing the net book value (NBV) of a company to its current market valuation.
The book value itself is determined by the value of total assets minus total liabilities. For example, a company with total assets of $500 million and total liabilities of $400 million would have a net book value of $100 million. Therefore, if the company were to sell everything and pay all its liabilities they would be left with this $100 million amount.
The total market value is calculated by multiplying the number of shares by the price of one share. For example, a company with 50 million shares each selling at $100 per share would have a total market value of $5 billion.
The book to market ratio is calculated by dividing shareholders’ equity by the market capitalization. So:
Book to Market Ratio = Shareholders’ equity / Market cap
A company’s book value indicates what would remain in terms of assets if the company were to cease trading and shut down.
Forward Earnings Estimate
This indicator takes into account previous performance in order to estimate what future results could be. Of course, past performance is no guarantee of future performance however it can be helpful to investors to try and visualize what the future could look like from an earnings point of view.
Forward earnings give projections of potential taxation values, profit margins, sales and also costs.
Value Premium or High Minus Low (HML) & Spread
As first pioneered by Fama and French in 2001, value premium is the difference or the spread between the returns garnered by glamour or “hot stocks” and value stocks. This is also referred to as High Minus Low and part of the overall Three Factor Model by Fama and French. The larger the actual spread between cheap stocks and the more expensive “glamour” stocks the more clarity the metric gives between those stocks that are more likely to underperform vs. outperform.
“Alpha” and Adjusted Performance
“Alpha” is part of the previously mentioned Three Factor model, introduced by Fama and French. An investment’s “alpha” is representative of the risk an investment poses. This alpha measurement gives an indication of how likely an investment is to beat the market in terms of overall returns. According to their model, a portfolio or investment which shows a stronger performance or return than similar companies in the market would indicate that there is untapped value that has gone unnoticed by “typical” analysis of the market. Vice versa, a weak alpha would suggest that there is a potential red flag in an investment that has gone unnoticed. The alpha is presented as the amount by which an investment has exceeded expectations, normally in percentage form.
When looking at adjusted performance it appears that EBIT over EBITDA is the most effective ratio to consider.
Capital Asset Pricing Model (CAPM)
This value is used to present the link between the expected return for an asset class (in this case stocks) and the risk involved in the investment, taking into account the cost of capital. The formula for CAPM is as follows:
Capital asset expected return = Risk free rate of interest + sensitivity x (expected market return – risk free rate of interest)
Because investors expect compensation for not only the risk, but also the time value which money represents, this is where the “risk free rate” component of the formula comes into play.
If we break this down, the risk free rate part of the CAPM formula accounts for the time value of money, and the other parts of the formula allow for the extra risk an investor is taking on in a particular investment scenario.
A potential investment has a beta component, which measures the amount of risk a particular investment will add to a portfolio that is similar in nature to the overall market. Therefore, a stock which is deemed to be riskier than the overall market will have a beta value greater than 1. Naturally, a beta value less than 1 would suggest a stock would help to de-risk a portfolio.
The beta value is multiplied by the market risk premium (calculated as the amount of return the market is expected to give above the risk free rate value).
The risk free rate is then added to the product of the above (i.e. the beta value multiplied by market risk premium). This finally gives an investor a required rate of return or discount rate needed to find the “true” value.
Ultimately the CAPM formula can be used to assess whether the value of a stock is fair when taking into account the time value of money and the additional risk of investing in the stock.
Price to Book (P/B) Ratio
The price to book ratio is a measure of a company’s stock price against the book value. Using this ratio to measure old industries such as manufacturing, banking and oil & gas companies can give an accurate insight.
The formula is as follows:
Price to Book Ratio = Share Price / Book Value per Share Price (BVPS)
If the result of this calculation is under 1, this is considered an undervalued stock so could be a good purchase, with a ratio of 1 being a “fair price” for the share. Investors need to be wary however, because a value under 1 does not necessarily mean a stock is a great buy. It could simply mean that it is cheap and there isn’t any intrinsic value with low upside potential.
A ratio above 1 would suggest that a company is overvalued, however this is not always accurate, due to the fact that different businesses have different overheads resulting in a net book value that does not fairly represent the company, effectively skewing the P/B ratio.
As we have seen above, there are a multitude of ways to value a company and its stock price, with profit yields, earnings estimated and enterprise values all being considered. One could argue that the EBIT and EBITDA methods are the most effective overall, however the popular Price to Earnings and Price to Book ratio are not to be underestimated, along with taking into account other considerations such as sales growth which can help give a “bigger picture” value of a stock and where it may be headed in the future.