Should you compare P/E ratios to determine a stock’s value?

There is a saying that something is only worth what someone else is willing to pay for it. No matter how much the seller wants to sell an asset, it is the buyer who ultimately sets the price. Without the buyer, there is no way to know how much an asset is really worth.

In the equities market, the worth of a stock is determined by the last trading price. Investors use this price as a reference for value. A stock may be considered expensive or cheap depending on its perceived valuation.

By practice, investors normally judge a stock’s valuation by comparing it with the market average. For example, if the current market P/E is 20x, any stock that trades higher than the average may be perceived expensive. Or a stock may be considered a bargain if it trades way below the market.

Avoid using other stocks to value another stock.

The use of relative valuation is very common. Many stock analysts and brokers often use this as a measuring stick in identifying buying and selling opportunities. While valuing stocks by comparison may seem simple and easy to understand, buying stocks based on this investment argument can be very risky.

For one, relative valuation can be subjective. Remember that a stock price is only worth what the market is willing to pay for it. When the market is bullish, some stocks that may be intrinsically overvalued may appear to be attractive by comparison. Imagine if the average market P/E is 40x, would you consider a stock that trades at 30x P/E cheap?

Valuing a stock by comparing with similar companies in the market may not be easy to do because every company is unique. Stocks may belong to the same industry but may differ significantly in terms of risks, financial structure and growth prospects.

For example, Robinsons Land (RLC) which currently trades at only 17x P/E may look grossly undervalued when compared to 36x P/E of SM Prime Holdings (SMPH). Because they both belong to the same industry, one would assume that RLC must eventually trade at par with SMPH.

Such assumption can be dangerous. While both companies share similar business models, they may differ in growth, profitability and risks. SMPH enjoys a premium over RLC because of its sustainable competitive advantage in terms of pricing power, strategic locations and market share.

Identify growth drivers to value a stock.

While using relative valuation can be a quick and dirty way to get a grip on assessing investing opportunities, finding the intrinsic value of a stock must come from its own fundamentals. Because every stock is unique, it is possible that a stock that trades at 25x P/E may still be an attractive buy while another stock that trades at 10x P/E may already be considered fairly valued.

To illustrate, let’s assume that the P/E valuation of a stock is dependent on several fundamental variables so that one variable, for example, the projected earnings growth rate, increases, the P/E multiples will also increase.

In this model, we shall use the 30 stocks of PSE index to represent the market in a simple regression that will predict the ideal P/E of a stock based on the following independent variables: earnings growth rate and market capitalization.

The result of this model is written as P/E = 12.65+ 5.46 x Earnings Growth + 0.06 x Market Cap, which means that the intrinsic P/E of a stock is determined by the company’s projected earnings growth rate and market size.

Based on this model, 19 out of 30 PSE index stocks turn out be to be undervalued. Some of these stocks with their target P/Es include Ayala Corp (26.5x), Aboitiz Equity Ventures (24.4x), Ayala Land (29.5x), BDO (27.3x), Metrobank (19.8x), Megaworld (17x), SM Investments (35x), First Gen (14.6x) and GT Capital (19.7x).

Note that many of these stocks are already trading above market P/E of 20x and yet they are fundamentally undervalued by earnings growth prospects. This exercise only demonstrates that the ideal P/E of a stock is not determined by comparison but by its internal metrics.

Now this model can be further strengthened by adding more independent variables to improve the correlation with the projected P/E. The additional variables are Debt-to-Equity ratio, Return on Invested Capital and Weighted Cost of Capital. The results show improved correlation to 44 percent with essentially the same results with more precise P/E values.

While comparing P/Es may be easy to use for picking stocks, every investor must know that the true valuation must come from its own fundamental merits.