Investing basics: How to value shares

With such diversity in the size, structure and strategy of companies to choose from, how do you know that the share price you are being asked to pay is a reasonable reflection of the performance of the business and how do you make an ‘apples and apples’ comparison of companies that appear to be totally different? – writes Christian Leeming

Perhaps of more interest to the stock-picker, how do you find companies that are currently undervalued and look to unlock a profit; unless you are looking to buy stocks for the certainty and magnitude of their dividends, the likelihood is that you are looking for that elusive diamond in a coal mine?

‘the likelihood is that you are looking for that elusive diamond in a coal mine’

The good news is that there are plenty of sources of data available to help you to form an objective opinion and by looking at a few key indicators it is relatively straightforward to form an initial assessment of whether a company represents good value for its share price or otherwise.

The first metric that is usually quoted divides the share price of a company by its earnings per share (EPS) – deriving its PE Ratio; this basically tells you how many times the EPS the share price represents.

Historical data will show you what multiple a company has traded at in the past and predicted future earnings are available in forecasts and updates issued by the company via a range of financial portals or your broking platform.

PE Ratio is not a definitive measure of whether a company offers good value at a particular price or not, but it can be useful to compare different companies or sectors; generally companies trading below 10 may be considered ‘cheap’, between 10 and 15 to offer reasonable value and beyond 15 to be becoming ‘expensive’.

Looking at forecast earnings per share in the context of historical PE Ratio performance can identify trends known as the price to earnings growth (PEG) ratio; however, any judgement about the future value of a company on this basis is dependent upon the accuracy of its forecast earnings.

‘it is an expression of what market participants consider to be fair value for that particular share’

Another commonly quoted metric when valuing a company compares its value with its earnings before interest, tax, depreciation and amortisation (EBITDA); whilst a little intimidating at first glance by taking away what can be variable influences on a company’s profit this measure delivers a more reliable picture of its core trading performance and one that makes for better comparison.

It is important to remain mindful of the fact that, whilst it may be very much influenced by it, a company’s share price is not a direct result of its performance; it is an expression of what market participants consider to be fair value for that particular share.

Whilst forensic analysis of a company’s balance sheet may unearth any amount of ‘evidence’ to support a particular valuation or investment decision, the reality is that, particularly in an age of information overload, there will be a whole raft of influences that are brought to bear on the market’s valuation of a share, some of which are predictable and others that may be less so.

Elsewhere on this site you will see a company called Heckyl introducing the concept of sentiment analysis whereby a whole range of non-financial events can be demonstrated to have an effect on share prices and for every mathematician that claims to have found ‘the’ formula, there will be someone who has beaten the market because he received a message through his coffee grounds or met a thoroughly decent chap in a wine bar.

By definition, to have a market, you have to have winners and losers; if outperforming the index is the Holy Grail and there was a proven way of achieving it, everyone would be doing it!

‘by applying some very simple rules about how you assess the prospects for a company and spreading your risk, you may just find that ‘tenbagger’’

Active fund managers look to beat the market with their superior investment strategy and insight, whereas passive managers believe that solid performance can deliver greater returns when coupled with ultra low costs; then there are active, passive funds that use complex formulae to try to unlock that elusive latent value.

Also on this site we look at a technique called momentum investing as propounded by Saltydoginvestor which contends that investors will join the crowd when they identify a trend – rising or falling – thereby exacerbating it.

Such an approach may be heresy to fundamental investors who will be equally convinced that the answer will be there in a spreadsheet, it is just a matter of teasing out that additional value and making a killing.

By investing in individual equities you are, by definition seeking that market beating performance; a FTSE 100 tracker would give you exposure to the performance of the index at a cost of 0.07% annual management fee, but that’s not enough.

So, equity investing can be something of a roller coaster, but hopefully by applying some very simple rules about how you assess the prospects for a company and spreading your risk, you may just find that ‘tenbagger’.