One factor in the valuation of the company does not often figure in the calculations of investors who go by the financial statements as they are presented. As a result they tend to go by the valuation of the company as a whole. Often, the company can be much more valuable if it is broken up and sold off piecemeal. In other words, in some cases, the value of the parts may significantly exceed the value of the company as a whole. This can happen, for instance, if the company has an asset that is undervalued on its books. For instance, the company may have significant real estate holdings that are valued at cost despite considerable appreciation. If these holdings are sold piecemeal, the value of the investor is going to be significantly enhanced. This can also happen if there is no real operational synergy between the parts and the under performing parts can depress the value of the company as a whole.
A popular method of stock valuation is to use com parables by using the figures for the earnings. If earnings are reduced to Earnings per Share or EPS, it allows for a sensible comparison of the company with like companies or other benchmarks. Most investors use what is called a trailing EPS because it is based on the historical results presented by the company and does not require additional calculation or adjustment on the part of the investor. You must keep in mind that the EPS figure on its own is not particularly helpful and it is necessary to look at the earnings of the company as a comparison to the current market price. The visual that makes it meaningful is called the Price/Earnings ratio or P/E ratio.
There are a large number of investors who use these so-called “multiples” who go no further than establishing the P/E ratio. They merely forward with their investment plans on the basis of this single number. Because stock valuation and equity research is not an exact science, this over dependence could hurt them dearly. People forget that Benjamin Graham who made this ratio popular used it in conjunction with a number of other valuation techniques. This simplistic approach will lead to the mistaken conclusion that a low P/E ratio is enough to justify an investment in any stock.
For a company that makes losses or whose earnings have declined in the previous year, this ratio becomes less important than other methods of valuation. So the ratio has to be used in the context of the growth of the company and not as an isolated measure. The measure still can be used as a useful filter to pinpoint stocks that justify further research and investigation. Very often, these stocks have low ratios because there is some doubt about the future or their growth prospects. You then have to study the growth prospects for the company in order to identify whether it is worth investing your money. This is not to say that this ratio does not help you find undervalued stocks but you need to put in a lot more work before you can justify an investment.
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