ASX Stock Valuation Methods

Valuing Stocks on the ASX

“Value” is one of those words that has multiple meanings –from the monetary worth of something to the importance, worth, or usefulness of something. When you invest in a stock you are buying an ownership stake in the company, no matter how small it may seem. What is that worth to you?

Value is essentially a subjective concept that depends on the person looking to assess the value of something. There are different types of investors with different time frames in share market investing. A short term trader is less interested in the things that contribute to the monetary worth of a company than the long term investor is. For both, there are a variety of approaches to assessing the value of a stock.

How Are Stocks Valued?

Fundamental analysis is an approach that takes multiple things into account in an effort to determine the intrinsic value of a stock. Financial analysts pave the way for individual retail investors with their valuation methods. In effect, retail investors can follow in their footsteps employing the same methods to a lesser degree.

Stock Valuation Methods

Companies publish financial statements called earnings reports outlining their financial performance over the full and the half year here in Australia. Professional analysts dig deep into those reports, extracting different items and then using them to calculate ratios that point to intrinsic financial value. This is called ratio analysis, arguably the most common valuation method for stocks.

Ratio analysis along with understanding earnings reports are two elements in the quantitative analysis of a company focusing on numbers, typically followed by a qualitative analysis focusing on non-quantifiable items.

Ratio Analysis

The most important and most useful valuation ratios appear on financial websites and trading platforms. They are:

• Price to Book (P/B)
• Price to Earnings (P/E)
• Price to Earnings Growth
• Dividend Yield

The P/B ratio compares a stock’s market value with its book value. The market value is determined by the current share price multiplied by the total outstanding shares of the company. In essence, market value is what investors perceive the company to be worth. The book value is determined by the company’s assets minus its liabilities. Both are expressed in the ratio calculation on a per share price. Market price per share is the latest price of the stock while book value per share is the book value divided by the shares outstanding.

Higher ratios indicate the market may be overvaluing the stock. Ratios under 1.0 indicate a bargain stock since the price per share is lower than the book value per share.

The P/E ratio may be the most used financial ratio of them all. The ratio shows how much investors are willing to pay for each dollar of earnings. The calculation divides the price per share by the earnings per share with some financial websites reporting either trailing P/Es or forward P/Es where the earnings per share figure is either “trailing” from the last financial reporting or from average analyst forecasts.

The P/E has drawbacks. First it is best used in comparison with peer companies or a sector index. High P/Es indicate the company’s earnings do not support its price. Low P/Es mean the company is earning more than investors are willing to pay. Finally, investors interested in start up companies will not find a P/E since the company has no earnings to report.

The comparison is essential as a high P/E on a technology stock is common in that sector. Tech investors are willing to pay for expected future earnings.

The P/EG ratio is considered a significant improvement over the standard P/E since it uses not forecasted earnings but forecasted growth rates. P/EGs of 1.0 indicate a stock is fairly valued. P/EGs under 1.0 indicate potential bargain stocks. P/EGs need comparison metrics from peer companies or sector indexes as well.

Dividend Yield is calculated by dividing the dividends paid by a company over a full year by the price per share. Dividends can be signs of a company’s financial performance since it reflects the amount of its earnings it is willing and able to share with its investors. High dividend yields should be viewed with caution as the yield will go up as the stock price falls.

Quantitative vs Qualitative Research

Quantitative analysis looks at hard data like financials while qualitative analysis looks at soft data like the quality of company management. Market experts strongly recommend retail investors analyse the stocks of companies they are targeting for possible assessment both quantitatively and qualitatively.

Ratio analysis is part of quantitative analysis. Financial analysts provide retail investors with a wealth of ratios in addition to the four core valuation ratios.

Financial statements and Full Year and Half Year earnings reports also include a cornucopia of hard data pointing to a company’s financial activities and health.

There are three financial statements published on most financial websites – the Balance Sheet, the Income Statement, and the Statement of Cash Flow.

The Balance Sheet overviews a company’s assets, liabilities, and shareholder equity, published for the three prior fiscal years. The Income Statement overviews a company’s revenues, expenses, net income, and earnings per share. The Statement of Cash Flow shows how cash is earned and spent.

Earnings Reports include both hard and soft data, including what the company makes and where it is sold, new products in their pipeline with expected release dates, information on the company’s top management, competitive advantage and industry position and more.

Understanding Earnings Reports

In Australia companies issue earnings reports twice a year – once for the full year and again for the half year. Reporting dates vary depending on how the company defines its fiscal year.

Most companies put out three releases – a press release with highlights, a truncated version limited to financials, and an investor presentation providing background information, future outlook, and market commentary.

Quantitative analysis of earnings reports focuses on the financial information with qualitative analysis looks at the background information and management commentary.

Professional analysts remind retail investors that companies go to great lengths to present as positive a picture as they can, even in difficult market conditions. Examples include burying negative net profit after tax (NPAT) at the end of the report while extolling positive EBITDA (earnings before interest taxes depreciation and amortisation) early and often in the report.

The best source of qualitative information is the company’s Annual Report. This report contains the financials, but explores the company in great depth, from the business model to detailed information on existing products and products in the pipeline, customer base, geographical markets, company culture, and manufacturing locations. The report typically includes the company’s mission and vision statements and a letter to shareholders.

Some reports end with a Management Discussion and Analysis section, where corporate leaders review the company’s financial condition, operational highlights for the year, and plans and expectations for the future.

Determining the value of a company an investor is targeting for potential investments is challenging, lacking a definitive answer, but there are methods investors can use to determine an imprecise value of a potential stock.

These methods include a more objective quantitative analysis focusing on numbers and a more subjective qualitative analysis of soft issues about the company, such as its mission and vision, corporate culture, and management quality.

Ratio analysis is at the core of quantitative analysis while earnings reports and the company’s annual report provide soft data for qualitative analysis.