So you want to be a stock picker? Make sure you have these useful valuation metrics in your arsenal.
Words by Sebastian Haq
Being a successful stock-picker isn’t just about being intelligent and well-informed or having the stars aligned in your favour.
It actually requires doing a lot of homework.
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As legendary fund manager Peter Lynch once said, “If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.”
Doing the homework means researching on the companies you’re interested in and assessing their financial health so that you can make informed investing decisions.
There are many metrics out there that can help you evaluate the attractiveness of a potential or existing investment, but these are the three key ones we think you really need to know.
1. P/E – The king of valuation metrics
Easily the most well-known, the Price-Earnings ratio is the granddaddy of all investment valuation ratios. It compares the current price of a company’s shares to the amount of earnings it generates, and is calculated as follows:
Example: The current price of Company A’s share is $20.38 and the earning per share is $1.61. This gives us a P/E ratio of 12.66 (20.38/1.61).
What this ratio does is to give you a quick idea of how much you’re paying for each dollar of the company’s earnings. Compare the current P/E ratio against the company’s historical P/E or the industry average P/E to get a sense of whether the company is considered cheap or expensive to buy. Historically, the average P/E for the stock market is 15.
A high P/E ratio suggests that investors anticipate higher growth earnings in the future. Growth investors tend to look at high P/E ratios favourably, as the stock is likely to continue increasing in value. Value investors, on the other hand, may be deterred by the high valuation and choose to invest in other cheaper undervalued stocks.
2. P/B – A conservative valuation metric
The Price-to-Book ratio, also known as the price-equity ratio, is used to compare a stock’s market value to its book value. The book value of a company, which is also its current net assets (assets minus liabilities), can be seen as the value of the company should it become bankrupt and liquidated.
P/B ratio is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.
Example: Company B has a current share price of $62.30 and the shareholder’s equity per share of $21.90, which gives a price-to-book ratio of 3.2.
A lower P/B ratio could either mean that something is fundamentally wrong with the company, or that the stock is undervalued. If that’s the case, the stock can be considered an attractive bargain, since shareholders would receive at least the book value if the company were to be liquidated.
[Fun fact: The famous Net-Nets strategy introduced by value investor Benjamin Graham targets such companies. When a viable company is identified as a net-net, it is about as close to a sure thing as you can get in the market.
What’s admirable is that Graham developed this strategy back when financial information was not as readily available and valuations were generally low. Today, such companies are practically non-existent in the market.]
3. PEG – The key metric for growth investors
The Price/Earnings to Growth ratio is a variation of the P/E ratio, and is used to determine a stock’s current value while taking into account its estimated earnings growth.
Example: Company C has a current P/E ratio of 12.66. The estimated growth rate of its earnings is currently 8%, according to an independent investment management firm stock report. This gives us a PEG ratio of 1.58 (12.66/8), indicating that the share is currently overvalued.
The PEG ratio provides a more complete picture than the P/E ratio, as investors can compare the P/E ratio to the estimated EPS growth to get an understanding of how much a company is overvalued or undervalued. While a high P/E ratio may make a stock look like a good bargain, factoring in the company’s growth rate may tell a different story. As a general rule of thumb, a PEG ratio of below 1 is desirable.
If the PEG ratio is below 1, it indicates that the EPS growth can surpass the current valuation of the company as given by the market. If the PEG ratio is 1, it means that the company is correctly valued against the P/E ratio.
Note that the P/E ratio is usually very easy to find, as it often appears together with the stock quote, whereas the EPS growth might require some digging in investment research reports and the financial press.