How to Evaluate Potential Stock Buys

Valuation Explained

Many investors throw around the term “stock valuation” very often, but what exactly does this term mean?

Wikipedia defines stock valuation as:

the attempt to give an estimate of a stock’s fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine potential market prices. (Source: Stock Valuations, Wikipedia.)

Deconstructing Stock Valuations

There are two inherit types of value: intrinsic value and market value. Intrinsic value is the actual value of a company when all the company’s assets, liabilities, and intangible variables are taking into consideration. Anytime you use a stock’s P/E ratio or Price/Book ratio to determine its value, you’re using valuations to determine a stock’s worth. On the other hand, market value is merely the current price that a stock trades at. Let’s look further into the various valuation ratios that investors can utilize to seek out bargains in the stock market/ETF market.

The Valuation Components

With the power of computers, investors can gain access to a company’s valuations with little or no guesswork involved. Large financial sites like Yahoo! Finance or Morningstar provide you with the following information that is necessary to accurately analyze a stock’s intrinsic value.

P/E Ratio aka Price over Earnings multiple - This ratio calculates the price of a stock divided by its trailing twelve month earnings to explicitly show how much an investor must pay for $1 in earnings. Since 1880, the average P/E ratio of the S&P 500 is 16.1. This explains why generally stocks with P/E ratios of 15 or below are considered bargains.

Ideal Range: As low as possible or within direct range of same industry competitors.

Future P/E Ratio - Future price over earnings operates like the current P/E ratio, except for the fact that investors use this calculation from the October months to the end of the calendar year. Why so? Because after October, you can no longer use the current P/E ratio to accurately gauge how much $1 in earnings will cost you in the future. It’s smarter to look forward into the future to access what you may be getting into. Unless the year is winding down, forward P/E ratios provide extremely irrelevant information in regards to the value of a stock. The future is never guaranteed, but if we are only 3 months away, we are willing to take that risk.

Ideal Range: Below 15 or within the range of direct competitors.

Price over Cash Flow - Price over cash flow is calculated by dividing the price of a company’s share by cash flow per share. When a company files their cash flow statement, they are documenting how much money went into or out of the business during a given time period. This ratio explains how much investors must pay for $1 in cash earnings per share. Since you are a shareholder in the company, you want management to increase retained earnings by holding onto profits from revenue once they receive them. A company that spends excessively often fails to return maximum value to the shareholders.

Companies use cash to distribute dividends, pay off their debts, buyback shares at a discount, and to reinvest back into the core businesses. When all else fails, I like to invest in companies that holds lots of cash.

Ideal Range: Relative to other companies within the same industry and sector.

Price over Sales Ratio - Divide a company’s market capitalization over total revenue, and you just calculated the P/S ratio, which tells us how a company’s size relates to its ability to generate revenue. It also reveals if a stock’s price has outgrown annual revenue figures with respect to historical P/E sales ratio. You want this ratio to shrink over time, if possible depending on long term market conditions.

This number can also be misleading; almost all businesses generate revenue, but how many take in profits as well? Thus, revenue ratios are a small part of the valuation process.

Ideal Range: As low as possible or within same industry or sector competition.

Price/Book Ratio - Simply divide the stock price over a company’s book value per share to calculate the ratio. Book value equals the company’s value on paper. If company XYZ had a book value of $90 million, then you would expect the company to be sold for $90 million + a premium on its value. This is the most useful ratio of all because book value closely mirrors a company’s true intrinsic value.

Legendary investor Warren Buffet frequently used the price over book ratio to determine the intrinsic value of a company’s shares. While earnings can be easily inflated (stock options, unexpected gains, etc), a company’s book value is calculated over longer periods of time. This is one of the most reliable ratios you will ever use.

Ideal Range: As low as Possible or beneath comparable industry players.

PEG Ratio - Take a company’s P/E Ratio, and then divide it by its estimated 5 year EPS growth to calculate the PEG ratio. This ratio is more useful for growth investors who invest in fast growing companies. It can be inconsistent since forward 5 year growth is only a prediction. Use this ratio with caution, or you could get burned if the projections are incorrect.

Ideal Range: Below 1 for growth at a cheap price; depends on your personal investing style.

What Does Valuation Reveal to Investors?

These calculations are only mathematical assessments that you could use to gain insight into a stock’s intrinsic value. It’s up to you to determine inefficiencies in a sector and how you should exploit these opportunities. I wouldn’t recommended buying a stock based solely on valuations. Instead, I would use the valuations to eliminate stocks from the research process. Then you can get down and dirty with companies that you wish to further investigate using annual reports, conference calls, fundamentals, retained earnings records, company news, etc. during your preliminary analysis.

Reader Responses on Stock Valuation Techniques

Last week, I asked my readers, “what factors do you consider when buying stocks?” Of those of you who responded, valuation was the most important factor to consider when evaluating stocks. I, like many other investors, like to use the methods stated above to locate inefficiencies within the stock market.

Brian from Baby Biotechs said:

Valuation is really the only thing I consider. Since I’m investing primarily in biotechs, I look for companies that have potential products (not FDA approved yet) that are being undervalued by other investors.

sJ from Rant About it said:

Valuation is really critical. If you can spot hidden gems, you will make excessive profits. But its easier said than done. I actually look for bargains (when the stock is red), but cross-check any red flags like insider trading and bad news/scandals. Strong track record isnt much helpful. Buying a stock based on its past performance is not going to work most of the times. The best thing to do is monitor a stock for a while and understand investor sentiments. How do investors/traders react to good news/bad news.

And there you have it! First, we defined, then deconstructed, and analyzed the methods behind stock valuations. Also, I want to thank Brian and sJ for sharing their opinions on investing in stocks.

Here are a few more articles on using stock valuations to your advantage:

Use PEG Ratio Instead of P/E Ratio

What The P/E Ratio Can Tell You About Market Direction

Valuations Don’t Mean A Thing Without Discipline

Stock Valuation Calculator - follows the DCF model that I posted about earlier.

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