☰
- Trade Now
- About Us
- Offerings
- Markets
- Research
- Knowledge Bank
- Help
- Franchisee
In the previous section, we looked at equity valuation using present value models. Another approach to equity valuation is the relative value approach. Under this approach, investors decide whether or not to buy a company’s stock by comparing it with stocks of other companies on the basis of certain financial ratios. In this section we will explore this approach.
If you wanted to buy something and had two differently priced alternatives to choose from, will you simply go ahead and pick the cheaper one? You would probably like to compare their prices vis-à-vis their benefits before selecting one. You would then pick the one that provides the greatest value for the given price. A similar cost-benefit analysis is performed when shopping for stocks. Investors like to know what benefits they will receive for the price they are paying for them. Fortunately, the benefits of owning stocks are quantifiable, unlike the features of other products you might buy. These benefits are in the form of a share in the future income, cash flows or dividends of the company; as well as in the form of a share in its assets or book value. To calculate the cost-benefit trade-off, the price of the stock is divided by these values. The ratios thus calculated are called price multiples. These multiples are then compared across similar companies to discover which of them offers the greatest value. Since this approach is based on a comparison between different companies, it is called the relative value approach. The idea here is that in an efficient market, share prices reflect company fundamentals perfectly. If there is inconsistency between the two, investors will spot them quickly and prices will soon appreciate to reflect what fundamentals warrant.
Traditionally, many price multiples are used for stock-picking. They include: price-to-sales (PS), price-to-cash flows (PCF) and price-to-dividends. However, the ones used the most are price-to-earnings (PE) and price-to-book value (PB). Let’s look at these individually.
Forward PE calculates the price an investor effectively has to pay for each rupee of future earnings of the company. Net income belongs to shareholders of the company, whether it pays it out as dividend or retains and reinvests it in the future, thereby leading to an increase in future dividends. This is why investors want to know exactly how much they are paying for each unit of earnings. Smaller the price, the better it is for investors.
The trouble with using multiples is that a low price multiple doesn’t always indicate a good investment opportunity. Sometimes, it is a true reflection of poor company fundamentals. Similarly, a high multiple is also sometimes justified. For instance, if a company is investing in a new facility or undertaking another venture that will lead to a major boost in future earnings, a high PE may be warranted. Similarly, a very low PE may also be justified by certain factors. This calls for further investigation. In the following segment, we will discuss certain ratios that are used for this investigation.
Equity holders are principally concerned about the recovery of their investment, along with the dividend due on it. To verify the safety of their investments and ascertain its growth potential, they seek answers to four questions:
These questions are answered by calculating four categories of ratios—profitability, liquidity, efficiency and risk (coverage) ratios. Companies that perform well along these parameters generally have justifiably high price multiples.
As mentioned above, efficiency is measured in two ways—the length of each cycle and the number of cycles completed in the year. The ratios that estimate the first are:
The other category of efficiency ratios calculate the number of days it takes for each cycle to get completed. They include:
Notice that each of the above ratios evaluates efficiency at one of the stages talked about earlier. Finally, we need to measure the total number of days taken in the completion of the entire cycle. This is done by adding the DOH and DSO and subtracting DOP from it:
*All averages in the above mentioned formulas are calculated by dividing the sum of opening and closing values of the asset/liability by 2. For example, average book value of equity is the sum of book value at the beginning and the end of the year, divided by 2.
Thus far, we have only discussed the blessings of ratio analysis. A word of caution is in order before we move ahead in this section. Following are some of the limitations of ratio analysis.
Value investing is the style of investing where investors pick stocks that they feel are undervalued or ‘cheap’, relative to their peers or in light of their own future prospects. This approach contrasts with growth investing, where investors are not much concerned about the price of the stock. They pick stocks that they believe will appreciate because the company will realize exceptional earnings growth in the future.
Value investing is based on the concept of intrinsic value. Intrinsic value is the price investors, in general, feel the company’s shares should trade at, given its fundamentals. A value investor invests in a stock when its market price is below the intrinsic value because he expects the price to appreciate to intrinsic value over time. Intrinsic value is estimated using price multiples. This is done in two ways:
Assume that a company is trading at a forward PE multiple of 12 while a group of its competitors are trading at an average multiple of 15. This means that for every unit of forward earnings of the company, you have to pay Rs 12, whereas for its competitors, it is Rs 15. since the company is cheaper than its competitors, you may buy it.
For the second approach, let’s assume that the company has an estimated forward EPS of Rs 20 and is currently priced Rs 360 per share. The competitors’ PE is the same. Now, we can calculate the intrinsic value of the company by multiplying the competitor’s PE with the company’s EPS. This comes out to Rs 300. Since the market price is above this, you may leave the stock alone.
Instead of using competitors’ multiples, a comparison can also be made with the historical values of the company’s own multiples. Further, investors generally like to use a host of multiples rather than just the one to calculate intrinsic value.
As mentioned earlier, investors must not rely on numerical values alone. They must employ their logic and evaluate why the company’s multiples are different from the industry’s. In some cases, on doing so, they may realize that even a higher multiple for the company is attractive owing to its fundamentals. On other occasions, a much lower price multiple may also not be attractive enough, as the stock may never appreciate owing to limited potential. Investors who get attracted by low price multiples and invest in such stocks may never see them appreciate. This is called the value trap.