Examining some stock valuation techniques
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
One of the basic tenets of value investing or buy and hold investing as it’s sometimes called is that stocks can trade both above and below what might be considered to be a fair value or a true intrinsic value. The expectation is that over a period of time, the price will move back to the true value… Stocks that are considered undervalued are bought whereas stocks that are considered overvalued or sold. The legendary investor, Benjamin Graham, considered to be the creator of value investing, formulated a way to identify the utmost fair value for any given stock. This is called the Graham Number. Stocks trading well below this number can be taken to be undervalued.
Only two factors are involved in this calculation namely in the earnings per share and the book value. The fair value of a stock is reckoned to be the square root of 22.5 multiplied by the EPS and divided by the book value per share. The underlying assumption of this equation is that shares that have a P/E of more than 15 or a price/book value of more than 1.5 are overvalued. Obviously, this is a fairly simplistic calculation and you will need to take into account other factors before acting on your calculation.
Another technique that is probably used much less than it deserves to be is the price to sales ratio or the PSR. This method values the stock on the basis of revenues and takes into account the fact that earnings can be temperately depressed or even negative. Even new companies in high-growth businesses can be valued by using this method. It is generally calculated by taking the current value of the market capitalization and dividing it by the revenues for the preceding 12 months. The market capitalization is calculated by multiplying the amount of shares outstanding by the current market price. For example if a company has one million shares outstanding and current market price of $50 a share, the market cap will be $50 million.
If you want to be conservative and facilitate comparison with similar companies, you have to take long-term debt into account in order to create a level playing field for comparison. Otherwise you would be equating a company which is highly leveraged to a company that has zero debt which on the face of it is wrong. You want to add the long-term debt of the company to the market value in order to arrive at a market capitalization. This is justified the logic that if you are acquiring a company, you are acquiring its long-term debt as well.
This is the technique that is often used in making acquisitions and you will often hear the term multiple of sales in determining the price of a merger and acquisition transaction. Many investors use this acquisition technique in valuing a stock for investment. The technique is also used in valuing companies that have made losses in the short term but expect to return to their share prices when the situation has been rectified. The loss making company is not valueless and it is viewed in the long-term as a going concern.
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