Thursday, April 27, 2006

Valuing a stock

This is the last step of the 7 Stock Screens and what I am going to write on is out of the book "Sun Tsu on investing" context.

How should you value a stock? In other words, is this stock expensive.

Wrong Method
A classic example:
My mother came into my room.

Mum: GH (my bro) tell me to buy Thomson Medical
Me: Hei Mum, HTL is a relatively cheap stock compare to Thomson Medical
Mum: How much?
Me: $1.32
Mum: Thats expensive, Thomson Medical is only 39 cents

And this is my explaination to her....

A stock price is not an indicator of a stock's "expensiveness". The right way should be using P/E ratio, where P is the current price of the stock and E the annual earning. Therefore P/E ratio = (current price of stock) divided by the (annual earning of the stock). As this ratio tells you what price you are paying "relative" to the company's earning capability.

Right Method

Using P/E ratio. However, even if you have done your research on the company (e.g. management, products, business structure etc) there are still a lot of factors to consider.

1)Updating P/E ratio.

This was mentioned by Yuanhan
"P/E ratio should be calcuated using the most recent 4 quarters earnings(that means it might be 1st quarter of 2006 + 3 quarters of 2005) instead of just 2005 earnings"

Yes, this method will give us a more up to date "expensiveness" of the stocks as their earnings ability are updated. After researching on this method, I discover others have already been using it. This "most recent 4 quarters" is also known as trailing twelve months (TTM) and is used in some stock analyst site like (US site). However, I do not think the business times use this method to update a stock's P/E ratio.

2) Comparing P/E ratio within an industry.

The average P/E of property sector might be 15 but that of Medical sector might be 20, therefore it a medical stock at P/E 17 is cheap compare to its own industry but expensive when it is compare to the average P/E of Singapore stocks.

However, you might also want to subdivide the sector such as property sector to "the developers" and "contractors". This becomes a very gray area. Of course subdividing it will give you a more accurate average P/E for you to compare with but doing too much reduce the sample size for you to calculate the average.

3) Paying premium P/E for niche market.

If a company can carve out a niche market within its own industry, you should be willing to pay a slightly higher P/E for their stock. It is actually an extension of point 2, sometimes the company is doing things so differently from its competitors (and must benefit from this difference), that you think it should be subdivided into a subsector by itself. The right way to do it is continue comparing with its closest competitors but you ask yourself if it is worth it to pay the premium (its P/E - Average P/E) for it.

This premium can be considered for these as well:

  • Strong Consumer Brand
  • Monopoly

4) Estimating P/E (forward P/E) by predicting the results of the coming 1 or 2 quarters.

The P/E might be expensive now as people are estimating the coming results to be excellent, greatly improving the TTM earnings and greatly reduced the P/E. You can say that they estimate the forward P/E to be very low.

Caution: this is very dangerous as high expectation of the company to be performing very good in the near future and yet with the company not producing the result will cause the stock price to get a double blow.

Sometimes it is easy to predict the forward P/E if the company has keep and always release the updates of their order book. For example, Sembmarine and Keppel Corp did that. It will be a bonus if you buy a stock that is trading at an average P/E but you estimate its forward P/E to be very low.

5) Comparing P/E with the company Compounded Annual Growth Rate (CAGR)

This is similar to point number 4, just that you are looking longer term. You should be willing to pay more (high P/E) for a company with consistent/predictable growth rate and high CAGR that is calculated over at 4-5 years. Although historical data on performance is not equivalent to future performance, but it is the best indicator you can find. It indicates that the company is able to perform irregardless of the economic climate. If the company is able to achieve the high growth year after year, the P/E will be revised downwards year after year and stock price will rise after each revision.


At 10:28 PM, Blogger hannie the bannie said...

I'm quite surprised that the listing by BT doesn't use TTM for the P/E value. In such a way, by the end of the financial year, the EPS data used in the P/E ratio will be almost 1 year outdated !

Another thing is that as of 31 March 2003, companies with market cap less than S$75 are not required to report quarterly results. This is under review currently.

At 10:53 PM, Blogger hannie the bannie said...

Of course I meant S$75m

At 11:58 PM, Blogger tradingdiary said...

Did not know about this regulation. Thanks for the information.


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