Thursday, August 19, 2010

Valuation Metrics

When you buy a company stock based on value, you are trying to pay a price based on what you perceive the value of the company plus your margin of safety. Whe you speculate, you are buying stock of a company based on what you think is the probability that there will be a buyer out there who will be willing to purchase your stock at a higher price. In general, SPECULATE at your own risk though I do not deny that occasionally you can make some easy money.

In general, be picky about valuation and do not rely on a single valuation metric because no individual metric can tell the whole story. You may not need to have a finance background ( I don't), but when you start practising how to look at these metrics, you will less likely buy/sell on impulse or hearsay than warranted.

1) For firms that is cyclical or has a spotty earnings history, use price-to-sales (P/S).Companies with P/S ratios lower than their historical average can be bargains sometimes, but pay attention to net margin. In general, firms with higher net-margin warrant higher P/S ratio. In general, industries with higher net-margin tend to be those with higher barrier to entry or wide economic moats.

2) The price-to-book ratio (P/B) is most useful for financial firms and firms with numerous tangible assets but least useful for service oriented firms. In general, firms with typically higher ROE would be worth a higher P/B ratio. For example, my average purchase of DBS is at P/B ratio of 1.07 ( after taking in consideration of the recent $1 billion Goodwill impairment).

3) Compare a company's P/E with the market, a similar firm or the company's historical P/E. Be aware of different growth rates or risks between the companies you are comparing. When comparing with the company's historical P/E, try to understand if the company's macro operating has changed. For example the average P/E of Singtel from 2000 to 2009 is 13.4 (minimum is 8.9, max is 15). My average purchase price of Singtel is at P/E 11.8.

4) Use PEG (PE over growth rate) with caution as fast-growing firms tend to be riskier

5) Check earning yields (inverse of P/E) and cash return (Free Cash Flow over Enterprise Value). Enterprise Value is simply the firm stock market cap plus its long term debt minus cash). The goal is to measure how efficiently the business is using capital (both debt and equity) to generate free cash flow.

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