Here are a few different ways to work out if a stock is cheap, fairly priced or overvalued compared to its competitors.
If you’re new to share trading, it can be tricky to decide what to invest in and how to work out if it’s good value. You might decide to invest in a major supermarket brand, but how do you choose between similar companies such as Coles and Woolworths? Perhaps you’ve heard friends and colleagues refer to one as “expensive” and the other as a “bargain” but aren’t sure how they’ve determined this.
In this guide we’ll teach you some simple methods for comparing the share prices of similar companies and discuss why it’s important to do this before spending your hard-earned dollars.
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Why should I value shares before buying?
No-one wants to pay more for something than they need to, and we all love a bargain. The most basic goal of investing in shares is to buy when the price is low and sell when it’s high in order to make a profit.
Valuing a company’s shares against similar companies in the market is one of the easiest ways to do this. It can help you work out if you’re potentially paying too much for a stock, if you’ve found a bargain buy or if you’re holding onto a potentially overvalued stock in your portfolio that you’d be better off selling and replacing with one of its competitors.
Technical versus fundamental analysis
There are two main methods used to value a stock: technical analysis and fundamental analysis. Technical analysis involves statistical charts and algorithms that analyse the share price movements to work out the underlying trend or market sentiment based on the number of people buying and selling the stock. Some investors combine parts of both strategies into their valuations, however in this guide we’ll be focusing on fundamental analysis only as this is the more practical starting point for new investors.
Fundamental analysis focuses on the intrinsic value of the shares as well as the relative value. Intrinsic value is the “true” value of the shares based on the company's fundamentals, that is, its financial statements including its earnings and debt. Relative value is determined by comparing businesses against their peers, for example, comparing the price of Wesfarmers shares with Woolworths shares, or comparing Westpac shares with CommBank shares. Let’s take a look at a few ways of determining a stock’s relative value.
Three ways to calculate the relative value of a stock
Many investors will use ratios to decide whether a stock represents relative value compared with its peers. There is an endless list of ratios, and they’re most effective when used together to compare similar companies. Here are three popular ratios.
Price-earnings ratio (P/E)
The price-earnings ratio (P/E) looks at a company’s recent or forecasted earnings per share (EPS) against the current market price of its shares. EPS is the portion of the company’s profits (or earnings) allocated back to each individual share. You’ll often see the term P/E with a number that is considered a “multiple” of the company’s earnings, which is a result of the ratio applied.
To figure out a company’s P/E, first look for its EPS figures, which will be readily available in the latest annual or quarterly report on its website. Then simply divide the current price per share by the EPS to find the P/E. (Tip: if the company has adjusted EPS figures, use these instead as they will take into account any one-off major expenses for the reporting period that might affect the EPS figures.)
Calculating the P/E
Let's say company ABC has a current share price of $100 and an EPS of $10 as stated in its latest report. By using this formula, the company’s P/E would be 10.The P/E ratio works best when comparing apples with apples, and most investors would argue a stock with a lower P/E compared to its peers is “cheaper” and could be undervalued. For example, if you’re considering two similar stocks in the financial industry and one has a P/E of 25 while the other has a P/E of 12, the latter would be considered as better value using this method alone. While there’s no definitive P/E that’s considered “good”, over the last 40 years the All Ordinaries (the oldest index, or tracking tool, of shares in Australia) has averaged a P/E of around 15, which is sometimes seen as a broad threshold for fair value.
Some investors are cautious when a P/E ratio increases substantially as investor expectations about the company’s performance may have jumped ahead of the company’s actual earnings growth. Investors might get caught up in the market hype and anticipate sizeable future growth, but if targets go unmet this could lead to the share price being overvalued.
Price-earnings to growth ratio (PEG)
The price-earnings to growth (PEG) ratio considers a company’s earnings growth. To figure this out you’ll need to find the company’s estimated earnings per share over the next year, which will be included in it’s latest report. To calculate the PEG ratio, use the P/E ratio and divide by the growth in earnings per share (EPS).
Calculating the PEG
Continuing on from our example of company ABC above, let’s say the company has an estimated EPS of $11 over the next year as stated in its report. This is an increase of 10% on its current EPS of $10. Using the PEG formula of the P/E (10) divided by growth in EPS (10%), we have PEG of 1.Like the P/E ratio, the PEG ratio compares peer performance. Again, there’s no set PEG ratio that is considered a definite “buy” signal, but fundamentalists may treat a stock with a PEG ratio below 1 as undervalued.
Price-book ratio (P/B)
Based on the underlying value of a company’s assets, the price-book (P/B) ratio offers a snapshot of a company’s value according to the book value of the assets on its balance sheet. P/B is calculated by dividing the current share price by the stock’s book value divided by the number of shares issued. The book value is worked out from the balance sheet as total assets minus total liabilities (or costs). The balance sheet with these figures is easy to locate in the company’s latest earnings report on its website.
Consider company XYZ. Its market price is currently $2, with 50 million shares on issue. Total assets are $80 million and total liabilities are $20 million (this equals a book value of $60 million). Therefore, the P/B ratio is: $2 / (($80 million – $20 million)/50 million) = 1.7
The closer the P/B ratio is to 1 (or below), the greater the perceived value of the stock. P/B is mostly used for mature companies with limited growth.
Some more tips to help you value a company’s shares
As well as the above ratios, which give you an idea of a stock’s relative value in line with similar companies, here are a couple more tips to help you work out if a stock is fairly priced or not.
- Broker recommendations. Major brokers like Morgans, Bell Potter and Patersons or banks like Goldman Sachs and JP Morgan release their own reports analysing certain companies. Within their analysis they’ll include either a buy (or strong buy), sell (or strong sell) or hold recommendation based on where they think the share price is heading.
- Broker price targets. Within these broker reports they’ll also include a price target for the company's shares. This is the price they believe the shares will reach within the next 12 months, based on their own analysis of the company and the market as a whole.
While relying on these broker reports to determine intrinsic value or investment opportunities could be unwise, these reports may offer a broader picture for a stock’s fundamentals.
It’s important to note that using one of the methods outlined in this guide on its own to determine intrinsic or fair value isn’t a sure-fire way of analysing an investment opportunity. The subjective nature of determining relative value will always lead to a variety of different opinions. Instead you would benefit from a combination of these methods as well as doing your own research into the company before making an investment decision.
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