Valuation is everything – but what are the best ways to value a stock?

This column is always stressing the importance of valuation. Russ Mould looks at four popular ways to decide if a stock is undervalued

This column may seem to spend an inordinate amount of time banging on about valuation. But none of us would walk into a restaurant or clothes shop and pay any price to eat or buy something just because we liked it. The same should apply to stocks. As stock market sage Jeremy Grantham puts it: “You don’t get rewarded for taking risk; you get rewarded for buying cheap assets.”

This prompts the question of how best to spot and measure “value”. There are lots of ways to do it. Here are four of the most popular.

1. Price-to-earnings ratio

This is the share price divided by the earnings per share (often the forecast number). A short cut is to divide the market value by estimated future earnings after tax and this explains what a p/e ratio really represents: the number of years it will take a company to earn, and thus justify, its market valuation, assuming profits stay unchanged. It is therefore worth asking yourself just how confident you are that a company will be trading well, or even be in existence, 10, 20 or 30 years down the line.

In theory, the lower the p/e the cheaper the stock, but care is needed. A p/e could be low because profits are about to hit a cyclical peak, or because the balance sheet is weak and the company risky. To cope with these challenges, many investors look at peak or mid-cycle earnings, especially if a company is suffering a cyclical trough in its fortunes, although they then supplement this with other valuation approaches.

2. Price-to-book ratio

Book value (also known as net asset value) per share is assessed by dividing shareholders’ equity on the balance sheet by the number of shares in issue. The share price is then divided by this figure to get the price-to-book ratio. Shareholders’ equity is total assets minus total liabilities and literally the net worth of the company’s assets today.

Any price-to-book figure close to, or below, one suggests a stock is looking cheap – that you are paying less for the assets than their real value.

The price-to-book ratio is a popular tool for measuring the worth of certain sectors, notably real estate companies, insurers, banks and housebuilders, since it gives a clear view of the actual value of their key assets.

3. ‘Enterprise value’ multiples

A company’s “enterprise value” (EV) is determined by adding its debt to (or subtracting its cash from) its market value. You should also adjust for pension deficits (which you add) or surpluses (subtract) and leases (add).

The EV figure tells you what it would cost to acquire the entire company, liabilities and all. If you wouldn’t want to own the whole thing because of its liabilities, why would you want to own even one share?

EV multiples are often used by predators such as trade buyers and private equity firms when they assess how much to pay for a company.

The EV can be divided by sales (EV/ sales), earnings before interest, tax, depreciation and amortisation (EV/ Ebitda) or operating free cash flow (“EV/OPFCF”) to give a range of valuation multiples that can be used to compare stocks with each other.

4. Discounted cash flow

A discounted cash flow (DCF) calculation is in theory the most scientific way to value a business. The idea of a DCF is to establish how much a firm’s future cash flow is worth in today’s money. This is referred to as the company’s “intrinsic value”.

There are four key elements of a DCF analysis: a basic operating free cash flow calculation (OPFCF is operating profit plus depreciation and amortisation plus change in net working capital minus capital expenditure); establishing forecasts for OPFCF over the next 10 years or more; determining an appropriate “weighted average cost of capital” (WACC); and discounting future OPFCF using the WACC to establish fair or intrinsic value for the shares.

“Deep value” investors swear by DCF forecasts because of the long time horizons involved and the way in which they force a clear assessment of risk. DCFS are often used for start-up companies that generate neither profit nor cash flow (and even in some cases no revenues) when they join the stock market. The assumptions that underpin the DCF must therefore be stress-tested more carefully.