Your Guide to Valuing a Company – Part II

Your Guide to Valuing a Company – Part II

I’ve sort of gone on a ‘women investing’ bent lately. After some informal research, I discovered that many women do want to invest, but they don’t know where to start. As it turns out, women have a different approach to investing. They are more conservative, slower to pull the trigger, and more likely to thoroughly research before making any decisions.

It turned out that many wanted to know how to value a company. So, last week, I started with a basic introduction to doing just that. Often called fundamental analysis, it’s just fancy way of saying you’re trying to work out the ‘intrinsic value’ of the company. In normal-people speak, that’s how much the company is worth (instead of what it is trading for on the stock market).

Today, we’ll look at another method for finding bargains in the stock market.

In most of the business rags, you’ll see commentators refer to a company trading at ‘something-something times earnings’. When you see this, they are talking about what the stock’s price-to-earnings ratio (P/E ratio) is.

Some investors use the PE ratio to look for companies that are cheap compared to their stock market value. Sometimes, when the shares of a particular company are rallying, the P/E ratio can help identify whether it has the ability to stay there.

The core of the P/E ratio, however, is a guide as to how long it will take to pay back your investment, assuming there is no change to the business. Think of it like this: If you have a $10 stock, with a P/E ratio of five, it means it will take five years for you to recoup your money if nothing changes within the company.

Nowadays, some investors look at the P/E ratio as a gauge on whether the company will continue to produce progressively large returns, reducing the ‘pay back’ period.

Arguably, there are many advantages to living in this digital age. Constant videos of cats and snowboarders hurting themselves are one benefit. More importantly for investors, though, most of the tools for fundamental analysis are now freely available on the web.

You can find the P/E ratio and many other bits of data on most finance websites like Yahoo Finance. It would be a similar story for most online brokers too. Generally, these figures are reviewed weekly if the data isn’t dynamic.

However, if you would like to practice your number-crunching skills, calculating the P/E ratio is much easier than the industry would have you believe.

You simply take the share price and divide it by the most recent earnings-per-share (EPS) figure.

Again, most online brokers and finance sites will have the EPS data on hand for you.

Let’s use BHP Billiton Ltd [ASX:BHP] as an example. The closing share price for BHP yesterday was $24.04. The EPS for 2016 was $2.19. As a formula, that looks like this: 24.04/2.19 = 10.97. BHP has a P/E ratio of 10.97. If you were to buy shares at that price, and nothing changed in the company’s price or dividend, it would take just under 11 years for you to receive income equal to what you paid for the shares.

Remember, because the share price constantly fluctuates, so does the P/E/ ratio!

On its own, it doesn’t tell us very much. However, the metal and mining sector has an average P/E ratio of 12.72. BHP being lower than this suggests that the blue-chip miner might be cheap. Generally speaking, anything under 20-times earnings is fairly reasonable.

Take Domino’s Pizza Enterprises Ltd [ASX:DMP] as another example. Even with the 10% share price fall this year, at $58 per share, the company still has a P/E ratio of 44.3. This is high. When ratios start climbing up to these levels, it means the market is expecting more growth from a company. In other words, if the company disappoints investors by marginally missing growth for instance, the share price could fall heavily.

That means a high P/E ratio could be a reason not to buy shares in a company.

Before you start scouring the markets looking for ‘cheap’ companies, there are some other things you should know.

Ask the right questions

All of this data is available on the web. For free. Which means that you don’t really have an edge over other investors. And remember, these numbers don’t tell you everything you need to know about a company.

Sometimes, all you need to do is ask a few simple questions.

Is the company making money? I promise you, this is often the easiest place to start.

Take one quick look at the firm’s financials. If the company is making money, that’s a good sign. Next thing, work out if they are increasing their earnings annually. 10 years of history is more than enough. Look for how much the revenue increases each year. Consistent, large growth tells you the company could still be in the expansion phase, and the share price still has plenty of room to grow.

However, if the gains in revenue are smaller each year, or shrinking compared to previous years, this is a sign the business is at the mature phase of the business cycle. In this case, don’t expect large share price growth. But companies at this point in their life traditionally have a stable dividend, so look for dividend growth.

A profitable business should spend less than it earns. Companies are no different to households. Ideally, their outgoings are stable each year. If you see big jumps in spending, look for reasons why. Often, an increase in a company’s outgoing will be a one-off purchase — like plant and equipment, or even a smaller business. Sit back and question whether this recent expenditure will add value to the company.

Once you’re brave enough to wade outside the top 200 shares listed on the Australian Stock Exchange (ASX), there’s one number you should pay close attention to. That’s how many shares are on issue.

This tends to generally affect smaller companies. Without the ability to access lines of credit — or reaching the peak debt levels with a bank — smaller firms do a capital raising to get some cash.

In order to do this, though, they must issue new shares. Any new shares issued will dilute the value for existing shareholders.

This isn’t always bad. The occasional capital raising over the years won’t hurt. It even gives investors the chance to increase their holdings at a discount to the current share price.

However, if a company is hitting up the stock market for new funds each year…this will show up in the number of shares on each issue. If the number of shares on issue increases each year, back away. It’s likely that whatever shares you buy will be diluted in a year or two.

On the other hand, strong companies reinvest in themselves. If you stumble across a company that is slowly buying back a percentage of shares each year, consider investing in that one.

Asking yourself some of the above questions will help you weed out the good from the bad quickly. You don’t always need to do the maths to find a decent company to invest in. Especially when you get most of the information for free on the internet.

At the end of the day, deciding what share to invest in is all about pulling the trigger. Sometimes the hardest step is actually trusting yourself and your analysis, and hitting that buy button.

I’ll be back next week to cover some of the basics on technical analysis.

Shae Russell,
For The Daily Reckoning

Editor’s Note: This article was originally published in Money Morning.

Shae Russell

Shae Russell

Drawing on her extensive experience, Shae is the lead editor of Markets & Money. Each day, Shae looks at broad macro trends developing around the world, combining them with her distaste for central banks and irrational love of all things bullion.

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