[Post 92] How to properly valuate a company?

Credit to growth investor from investing note(investing note has lots of good tidbits)

These are the valuation metrics that are commonly used:

- Price to Earnings Ratio (P/E)

- Price to Book Ratio (P/B)

- Discounted Cash Flows (DCF)

- and others…

P/E: This is the simplest of all. It is simply = Share Price divided by Earnings Per Share (EPS).

Trailing P/E refers to Current Share Price divided by the EPS over the past 12 months.

Forward P/E refers to Current Share Price divided by the forecasted EPS for the next 12 months.

A layman’s interpretation of P/E is how much I am willing to pay for the company’s earnings. Example: A P/E of 15 means I am willing to pay 15 times per share for its earnings.

To me, P/E by itself is quite meaningless. It is useful only if you compare the company to its peers’ P/E or the industry average P/E, to judge whether it is under or overvalued.

P/B: Book value is the amount of cash I would get if I were to liquidate the company *today*. It’s like the “net worth” of a company. It is the sum of assets minus total liabilities. Sometimes “Net Asset Value” is used loosely interchangeably as “book value”. Book value per share is simply the book value divided by the total number of shares. P/B is thus Share Price divided by Book Value per share.

A P/B smaller than 1 means the share price is undervalued in terms of book value, while a P/B greater than 1 means overvalued. A P/B ratio < 1 simply provides an assurance to the shareholder that he/she can get back all (in theory) of his invested capital if the company was to go bankrupt.

Simplified Example: If I pay $1 for a share of a company with a P/B of 0.5, and if the company was to be liquidated today, I will in theory get back $2 as a shareholder. In practice this may be less than $2 due to expenses for liquidation and other factors. On the contrary, if I bought a share worth $1 of a company with a P/B of 2, I will at most get back $0.50 if the company was liquidated.

In summary, P/B looks at the value of a company at the point in time when the book value and P/B ratio were calculated.

The problems with using P/B is that it does not take into account the *future* earnings of the company and assumes the total value of its assets is correctly calculated. A company with a P/B ratio of 0.5 does NOT necessarily mean it’s a wonderful company with strong revenue growth.

There are many companies whose P/B ratios remain quite constant through the years. Eg. property development companies.

DCF: This refers to the sum of future Free Cash Flows (FCFs) that can be potentially generated by a company, discounted to present value. It is typically used by value investors to calculate a DCF-based fair value.

To understand this, you need to know the concept of “the time value of money”. In layman’s terms, “time value” refers to the fact that a dollar today may not be worth a dollar in the future due to inflation or deflation. So if a company can generate $2 mill of FCF in the future, I need to discount it to present value to assess what this future $2 m is worth today.

The simplified formula of a DCF-based fair value = Sum of Discounted FCFs divided by number of shares. The calculation can be much more complex due to what is the correct discount rate and the growth rate of FCF to use.

The advantage of using this is that I can judge a company’s worth or fair value by taking into account its future FCF growth (i.e. earnings growth). It definitely provides a more accurate view of a company’s future vs P/B ratio.

The downside of using DCF is that it is very sensitive to the inputs you use (discount rate, growth rate, etc.), hence “garbage in, garbage out”. The calculated fair value can vary a lot based on the input parameters. Also the psychological aspects -- sometimes we may tweak the inputs to our liking subconsciously, hence deriving an overly optimistic fair value.

As stock prices are typically driven by strong revenue growth (as per my observation), using DCF-based fair value will be more appropriate over P/B ratio if you want to maximise investment returns.

In conclusion, P/E and P/B ratios provide a very limited view of a company’s future growth. DCF valuation is often more appropriate. Having said all these, valuation metrics still pretty much serve as a rough estimation and guideline only. In reality, the market may be irrational (esp in the short-term) and many participants do not obey valuation metrics.

Hope this helps!