Stock Valuation: An In-Depth Analysis
Investing often involves understanding valuations. Today, let’s summarize the basics. Traditional valuation methods can be divided into relative valuation methods and absolute valuation methods. Each method has its pros and cons, mostly applicable to companies with a high degree of business maturity and stable revenue and profit. See the chart below for details.
1. Price-Earnings Ratio (PE)
PE (Price-Earnings) is one of the most common valuation metrics.
Calculation formula:
PE = Stock Price (Price) ÷ Earnings Per Share (Earn) = Market Capitalization ÷ Annual Net Profit.
For example, suppose I have a steamed bun shop that makes a net profit of $50,000 annually. That’s my annual net profit.
You are interested in my shop and offer to buy it for $500,000. The market value of this steamed bun shop is $500,000. $500,000 divided by $50,000 equals 10, and it will take you 10 years to recoup your investment. This 10 is the Price-Earnings Ratio. Generally, the lower the PE, the faster the payback, and the greater the potential for profit.
Different calculation methods lead to different types of PE: static PE, dynamic PE, and trailing PE.
However, PE also has some shortcomings.
Since PE is closely related to the company’s market value and profitability, it is suitable for industries with relatively stable profits and weaker cyclicality. For instance, the consumer and pharmaceutical industries, as everyone needs to eat and see a doctor every year.
For volatile industries that may even have negative profits, such as cyclical industries, PE is not a very useful indicator. For valuation in these industries, it is better to refer to the indicator we will mention later: Price-to-Book Ratio (PB).
Moreover, PE has a certain degree of lag, and it cannot reflect the growth of profitability. For a company with high growth potential, its current profitability might be weak, but it may have a higher growth rate in the future. For such companies, using PE for valuation is not very appropriate.
Lastly, the absolute value of PE often does not tell the whole story. A low PE does not necessarily mean it has investment value, and a high PE does not mean it is not investable. This point will be further explained in the section on ‘PE Discrimination’ later on.
2. Price-to-Book Ratio (PB)
Price-to-Book Ratio = Stock Price (Price) ÷ Book Value Per Share (Book Value)
The Price-to-Book Ratio indicates the ratio of the stock price to the company’s net assets per share.
For example, if the stock price is $10 and the Price-to-Book Ratio is 2, then for every $10 spent, you can buy $5 worth of net assets of the listed company.
PB is particularly suitable for companies with unstable profits, such as cyclical industries like steel, coal, and non-ferrous metals. The profitability of these industries fluctuates greatly, but they generally have more fixed assets, and their net assets are more stable, making PB a better indicator to judge valuation. Additionally, the securities and banking sectors are typical industries that apply PB.
Generally, a low Price-to-Book Ratio implies lower investment risk.
Different industries have different values for the Price-to-Book Ratio; for instance, the banking sector with a Price-to-Book Ratio within 1.5 times; the home appliance-based manufacturing industry within 2 times; and the steel-based construction material industry usually within 1 times. Anything above 5 is likely to be overvalued. Sometimes, stocks may experience a ‘net break,’ meaning the stock price falls below the book value per share.
3. PE/PB Percentiles
For PE and PB, absolute values are often hard to judge whether they are low or high.
Especially between different industries, there is a phenomenon of ‘PE Discrimination.’ For example, the coal industry’s PE peak over ten years was 10.95, showing a downward trend year by year, with the current average at 6.59. In contrast, the internet and software industry had a minimum PE of 34.3 times over ten years, with the maximum value reaching 1143.
In such cases, referring to the ‘percentiles’ of PE and PB is more valuable.
Take the PE percentile of the CSI 300 Index as an example. The current percentile indicates what percentage of the past values the current PE exceeds. For instance, a percentile of 90.80% means it surpasses the values of 90.80% of the time in the past, clearly indicating a high position.
The time period can be selected on various websites, generally suggesting a period of over 5 years to cover a complete bull and bear market cycle.
The same principle applies to PB percentiles.
Generally, the lower the percentile of PE and PB, the better. The lower the percentile, the further it is from the historical mean. Once the valuation is restored and rises back to the average level, there is a greater potential for profit.
Usually, if the percentile is below 20%, it is considered undervalued and has investment value. Above 80% is considered overvalued, requiring caution and consideration of whether to sell. Between 20% and 80% is relatively reasonable.
It is important to note that the core of PE and PB percentile valuation is that valuations will revert or converge to the historical mean.
However, if an industry undergoes fundamental changes, the historical center of PE and PB will shift up or down overall, making the percentile less meaningful.
4. Price/Earnings-to-Growth Ratio: PEG
PEG = PE ÷ (Annual Earnings Growth Rate * 100)
For example, if a stock has a PE of 10 and its earnings growth rate is 10%, then the PEG ratio = 10/10 = 1.
This indicator compensates for the insufficiency of PE in estimating the dynamic growth of a company.
Generally, a PEG near 1 means the stock valuation may be reasonable, less than 1 indicates it may be undervalued, and greater than 1 indicates it may be overvalued.
Many fund managers prefer to invest in companies with low PE and high earnings growth rates, meaning the lower the PEG, the greater the investment value.
5. Return on Equity: ROE
Return on Equity (ROE), is a beloved indicator of Warren Buffett. He once said, ‘If I had to use only one measure to pick stocks, I would use ROE (Return on Equity). Companies that can maintain a ROE above 20% consistently over the years are good companies, and investors should consider buying them.’
ROE = Net Profit ÷ Equity attributable to the parent company = Earnings Per Share ÷ Book Value Per Share
It reflects the company’s annual return on net assets and is unrelated to the stock price, representing the company’s profitability.
For example, Xiao Wang opened a clothing store in the community, investing an average of $1 million (net assets) over the year, with a net profit of $300,000. Then, the store’s ROE for the year is 30%, or 30/100 * 100% = 30%.
Generally, the higher the ROE, the better, as it represents the company’s ability to make money.
6. Equity Premium: FED
Equity Premium = Inverse of Wind All A-Share PE – 10-year National Development Bond Yield
This indicator represents the portion of the ‘market return’ of the stock market that is higher than the ‘risk-free rate’ of the bond market.
The higher the premium, the more worthwhile it is to invest in the stock market; conversely, focus on the bond market.
7. Enterprise Value Multiple: EV/EBITDA
EV/EBITDA is a widely used company valuation metric. It reflects the ratio between the market value of invested capital and the enterprise’s earnings for the next year.
EV/EBIT, EV/EBITDA
EV/EBIT, EV/EBITDA, also known as Enterprise Value Multiple, is a widely used company valuation indicator. The formula is: EV ÷ EBIT, EV ÷ EBITDA. Investment application: EV/EBIT, EV/EBITDA, like the relative valuation method indicators such as Price-Earnings Ratio (PE), are used in the same way. A higher multiple compared to the industry average or historical level usually indicates overvaluation, while a lower one indicates undervaluation. Different industries or sectors have different valuation (multiple) levels.
EV
EV (Enterprise Value) represents the enterprise value, a way to measure a company’s value, often appearing as a direct alternative to market capitalization.
The calculation formula for EV is: EV = Market Capitalization + Interest Bearing Debt + Preferred Stock – Excess Cash. (EV = Market Capitalization + Interest Bearing Debt + Preferred Stock – Excess Cash)
EV = Market Value + (Total Liabilities – Total Cash) = Market Value + Net Debt
The difference between EV and Market Value
People often regard EV as the theoretical price for a takeover. In mergers and acquisitions, the acquirer must bear the liabilities of the acquired company, which increases the cost of the acquisition. However, at the same time, the cash and cash equivalents of the acquired company will directly fall into the hands of the acquirer after the acquisition, reducing the acquisition cost for the acquirer. EV more rationally reflects the acquisition value or true value of a company, which is a market-recognized standard for enterprise value, although it may feel a bit ‘intangible,’ but many times, you have to admit its existence.
EBIT
EBIT (Earnings Before Interest and Taxes): EBIT stands for earnings before interest and tax, meaning the profit before deducting interest and income tax, or profit before interest and taxes.
EBIT = Net Profit + Income Tax + Interest
EBIT = Operating Profit + Investment Income + Adjustments for Previous Years’ Profits and Losses. (But excluding non-operational income and expenses)
EBITDA
EBITDA (Earnings before interest, tax, depreciation, and amortization): EBITDA equals operating profit plus depreciation expenses plus amortization expenses. Where operating profit = gross profit – sales expenses – administrative expenses.
Intangible asset amortization ≈ Beginning balance of intangible assets – Ending balance of intangible assets + Original value of newly added intangible assets – Net value of sold intangible assets during the period.
Long-term prepaid expenses amortization ≈ Beginning balance of long-term prepaid expenses + Initial amount of newly added long-term prepaid expenses – Ending balance of long-term prepaid expenses.
Cash paid for interest ≈ financial expenses; or replace it with the net amount from the ‘distribution of dividends, profits, or payment of interest’ in the cash flow statement after subtracting the dividends or profits paid.
The difference between EBIT, EBITDA, and Net Profit:
EBIT is mainly used to measure the profitability of a company’s main business, while EBITDA is mainly used to measure the cash flow generation ability of the company’s main business. Both reflect the cash flow of the enterprise and are two indicators that investors in the capital market pay more attention to. By excluding some factors in the calculation of profit, it makes the calculation of profit more convenient for investors to use. The main difference from net profit is that it excludes the impact of capital structure and tax policy. In this way, between different companies in the same industry, regardless of how much the income tax rate and capital structure differ, EBIT and similar indicators can be used to compare profitability more accurately. When analyzing changes in profitability over different periods for the same company, EBIT is also more comparable than net profit.
The advantages of EV/EBIT, EV/EBITDA:
Firstly, one of the prerequisites for using the earnings-based comparable method is that earnings must be positive. If a company’s forecast net profit is negative, then PE becomes invalid. In contrast, since EBITDA has fewer items deducted, it is less likely to become negative compared to net profit, thus having a wider range of use than PE.
Secondly, as financial expenses are not included in the EBITDA indicator, it is not affected by the company’s financing policy, making companies with different capital structures more comparable under this indicator. Similarly, since EBITDA is a pre-depreciation and pre-amortization profit indicator, different depreciation policies between companies will not affect the above indicators, avoiding the impact of differences in depreciation policies and abnormal depreciation on the rationality of valuation.
Lastly, the EBITDA indicator does not include other income items such as investment income and non-operational income and expenses, representing only the operational performance of the company’s main business, which also makes the comparison between companies more pure, truly reflecting the operational results of the company’s main business and the value it should have. Of course, this also requires separately evaluating the value of long-term investments and adding it back to the shareholder value in the final calculation results.
The shortcomings of EV/EBIT, EV/EBITDA: nothing can replace the cash flow statement, unreal interest payment rate, ignoring the quality of performance, making the company value appear cheaper than it actually is.
8. Discounted Cash Flow Model (DCF)
The Discounted Cash Flow Model (DCF) is a method of valuing a company by using a series of projected future cash flows, discounted back to their present value.