Price is what you pay, value is what you get
One of the famous sayings of Warren Buffett teaches us that in investing, pricing a stock is not the same as valuing that stock.
For years, investors have been using the price-to-earnings (PE) multiple as a tool to gauge whether a stock is undervalued or overvalued.
A stock may be considered cheap if its PE ratio is lower than the market average, while if it trades at a high PE ratio, the stock may be deemed expensive. Very often, it is also a common practice among stock analysts and brokers to price similar stocks with comparable PE ratios.
For example, if the PE ratio of Megaworld is 4.6 times and Ayala Land’s PE ratio is 14.4 times, we can say that by relative pricing, Megaworld is a bargain at 68 percent discount to Ayala Land’s earnings multiple. By computing for the PE ratio of a stock, one can quickly assess if a stock is worth buying or not by simply comparing it to the market or with another similar company.
However, if we are looking to compute for the intrinsic value of a company, it is not safe to use PE ratios as a measure of value for two reasons.
First, PE ratios do not account for long-term growth. PE ratios normally are computed based on a previous 12-month earnings.
For example, during this time of crisis when share prices are depressed against earnings last year, PE ratios do not reflect the recessionary effect on future earnings.
Some stocks may not necessarily be cheap just because they trade with low PE ratios. The fact that share prices are low may signal that something is wrong with the company.
In the same token, there are stocks with high PE ratios that are not expensive. Rising share price may indicate that there is a strong demand for the stock because of high market growth expectations.
Second, PE ratios do not reflect the risks of the company. For example, JG Summit and San Miguel Corp. have similar PE ratios of 11 times but they differ on their capital structure.
San Miguel has more aggressive debt-to-equity ratio of 3.7 compared to JG Summit, which has lower ratio of 1.7. The different leveraging strategies reflect the amount of risks taken by the two companies, which are not reflected in their PE ratios. Remember that the value of stock is the present value of its expected earnings. The value that we want to get must be higher than the price we pay. The higher the value over the price, the larger the margin of safety.There are two key drivers that determine the intrinsic value of a stock, the risk and growth of a company. To get high valuation, we need to find stocks to have high growth and low risk.
But in this kind of market environment, we will probably find stocks mostly with low growth and high risk that have intrinsic values lower than their share prices, making them overvalued at current PE ratios.
To value a stock with risk and growth, we can simply discount the expected earnings representing as free cash flow to equity by the difference of a company’s risk, which is its cost of equity and growth.
For example, if we look at the pricing of the upcoming initial public offering of MerryMart, we can estimate a forward PE ratio of 40 times, which may be perceived expensive in the market.
But if we compute for its intrinsic value, the stock’s value can come out reasonable depending on the growth we assume.
Given the 10-year bond yield at 3.2 percent, we can estimate the stock’s cost of equity at 5.14 percent. Using this rate with assumed long-term growth of only 3 percent, we can estimate the stock’s value at P1.14 per share.
If we raise the growth to 4 percent, given its ambitious expansion, the stock could be valued at P2.15 per share.
PE ratios may be helpful in picking stocks by market comparison, but to know a stock’s inherent worth, one must know its fundamentals that drive its value. INQ
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