How do you tell whether a share is undervalued or overvalued?

Typically when we refer to value in the stock market we’re talking about the value of the underlying company. This is different to terms like ‘overbought’ or ‘oversold’ which we often hear in technical analysis focusing purely on price movement.

Today we’ll be focussing on the fundamental value of a company.

PE Ratio

There are many ways to value a company. The simplest of these is the price to earnings ratio often referred to as the PE ratio. This ratio is calculated by dividing the price by the earnings per share (EPS), e.g. if the closing price of a share is $4.00 and earnings per share for the past year was 25 cents, then the PE ratio will be 16.

Price / EPS = PE Ratio

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On average the market PE ratio is 15, so a share with a PE ratio less than 15 is considered undervalued and a PE ratio higher than 15 is considered overvalued.

Unfortunately determining undervalued or overvalued is not quite this simple because the PE ratio is based on historical earnings, (i.e. last year’s) and doesn’t take into account what may happen in the year ahead. Perhaps the overvalued share has just been awarded a new contract, which will mean a big earnings jump, or maybe the undervalued stock has just lost one, which will have the opposite effect. It’s very important to look at the growth in the company as well as the current PE ratio.

PEG Ratio (Price Earnings to Growth Ratio)

In some situations the PE ratio may be very high and the share could still be undervalued. The reason for this is that the company is growing its profits very strongly and the share may become good value in the near future. The PEG ratio helps us determine how growth will impact on underlying value.

This is calculated by dividing the PE ratio by the EPS growth, e.g. if the PE ratio is 20 and the EPS growth is 30% then the PEG ratio will be 0.67.

PE ratio / EPS growth = PEG ratio

If the PEG ratio is low, less than 1, then the company is considered to be undervalued, while a PEG ratio greater than 1 suggests it’s overvalued. Within a short time the growth of the company would make the price justified given the expected earnings growth.

Intrinsic Value

For a more sophisticated approach we can calculate a company’s value based on its earnings.

These calculations typically take into account the future earnings of the company and discount them back to a current value. There are a variety of different models used, including the Net Present Value, Discounted Cashflow or Capital Asset Pricing. These are fairly complex mathematical models and for most investors it’s preferable to get these models calculated by companies that provide this type of data.

The calculated value is often referred to as intrinsic value or fair value. Once you’ve determined the intrinsic value of the company, any price below this level is considered to be undervalued and any price above is considered to be overvalued.

Warren Buffet’s Approach

Warren Buffet calculates the intrinsic value of a company using a different model to the ones above. Warren Buffet views a company’s long term growth in share price to be related to its growth in earnings. This can be expressed as the following simple model to value the company.

(Return on Equity/Required Return) x Equity per Share = Valuation

The required return can vary from investor to investor, but should reflect the fact that by putting your money in the stock market you are taking on a higher level of risk than by leaving it in the bank.

Typically a required rate of return of 10 – 15% (after tax) would be used. The equity per share is calculated by dividing the net assets by the number of shares on issue. Both the return on equity and equity per share figures are available through The Bourse and Market Analyser market data platforms.

Let’s value ANZ using this method, taking data from their latest report.

Valuation = 6.76% / 10% x (28,295,000/2,158,000)

= $8.86

So by this measure we’d consider ANZ trading at $25 to be overvalued. You can see from the screen below that the ROE was the lowest it has been in almost 10 years, so if we were to use a higher figure of say 9% this would boost the valuation to $11.80.

If we were to expect a greater return than 10%, say 12%, then the valuation would drop to $7.39.

Conclusion

Any of these valuation methods could be used to determine whether a share is undervalued or overvalued. The last valuation method is one of the toughest available and it will severely limit your choice of undervalued shares. Despite this (or perhaps because it) it has served Warren Buffet well over the years and is likely to reward the patient investor.

Damian Isbister CEO Software and Online Trading, TraderDealer