Another important valuation tool used is price-to-book or P/BV ratio. This ratio indicates to what extent the company’s share price highlights the shareholders’ portion in the business.
It is calculated as:
P/BV = Share price / Book value of one share (BV)
BV = Share capital + reserves and surplus
A high P/BV ratio (>1) implies the company’s stock is undervalued or the company earns revenue and is expected to see a higher return on the assets. On the other hand, if the ratio is < 1, it implies the stock is overvalued or the company does not earn a good return on the assets.
It is an excellent measure to value stocks of companies involved in capital intensive businesses like banks, auto and manufacturing. But don’t use it for companies operating in IT and pharma sectors as these companies how very low tangible assets.
However even this ratio does have its share of drawbacks.
• It does not represent the true value of stocks in services sector.
• It fails to represent the true value of companies with high debts. This is because high debt offsets the value of the company’s assets. This can lead to errors in taking investing decision.
Last time, we saw that just PE ratio is not enough for us to understand the true valuation of the company. There are many other aspects you need to look at when choosing a company for investment. One of them is called as Discounted Cash Flow (DCF).
DCF is the most complete valuation method. It consists of predicting a company’s expected cash flows and then discounting them by your expected rate of return from the stock to its present value.
If the value obtained from DCF valuation exceeds the present market price of the stock, the stock can be considered to be a bargain. If it is less than the current price, then sell the stock.
For this, you need the following 4 factors:
• Free cash flow: Free Cash flow is the amount of money that can be withdrawn from business without affecting the company’s business. It is responsible for determining the company’s investment worth. However calculating it is very complex, so instead you can use net cash generated by the company in its last year of operation. You can get this figure from the company’s balance sheet.
• Discounted rate: It is the rate of return that you think the stock will generate. Keep it realistic to prevent disappointments later on. A rate 15% can be considered to be realistic and is twice the rate of risk-free return.
• Period: To calculate DCF, you need to find out the life expectancy of the company or the period by which you can expect to recover your money. If you are not able to estimate this period, you can assume it to be 5-10 years.
• Residual worth: Usually lifespan of most businesses exceed 5-10 years than what we had estimated above. Hence it becomes essential for you to assign a value to remaining life span of the company. This can be achieved by adding the company’s current net worth or asset value to previous year’s cash flow.
You can then enter these figures in an Excel sheet to get the figure that the company’s shareholders will earn as net cash from its operations for the period under consideration. From this figure, the company’s present debt is deducted and the balance is divided by the company’s equity to get the DCF.
As we saw last time, P/E ratio plays a vital role in valuation of a stock. It indicates the margin of safety of the stock. It tells you about the relationship between the stock price and the earnings of the company.
Let us say you buy a share of company A that gives you a return of 9% in one year. Here the margin of safety is zero as a traditional bank account also offers you the same return, but without any risk.
So in order to lower the risk, the difference between both of them must be higher. The renowned investor Warren Buffett advises us this difference must be at least 1.25 – 1.5%.
But be warned: when the markets are on fire, each and every stock gets high price. Hence it makes the task of detecting stocks having higher margin of safety quite difficult. But during the bear run, it can throw up the plethora of opportunities for long term investors.
In the next part, we take a look at the drawbacks of this ratio.