Thursday, August 24, 2006

Non-PE stock valuation metrics 2 comments

DanielXX's intro: This is extracted from an article by Yeoh Keat Seng, the chief executive officer of Commerce Trust in Malaysia, on alternative stock valuation metrics. Sometimes they might be more relevant than PE as the best single valuation metric in certain situations, eg. where earnings growth is not steady, or where the value of the business is in its assets, or where one wishes to estimate takeover/acquisition value etc.

(P.S: The following were extracted from another source and is not my original work.)

There are many other valuation models in use today. Some are as easy to grasp as the PE, and yet no less powerful in application.

Others are more esoteric, having been developed in more recent times to overcome the limitations of the PE model.

The dividend yield model is widely accepted because it is simple and unambiguous. It is the ratio of the gross dividend a company pays in a year to the share price. As the name suggests, it indicates the cash return you earn from investing in the company’s shares.

You can think of dividend yield as being one of the two components of total return from your investment. When you invest, the hurdle rate is your opportunity cost of funds, say FD rate of 3.5%.

A stock which provides you with a dividend yield of 5% is obviously a candidate to switch your funds into, assuming its other attributes also fit the bill.

Since the higher dividend yield compensates for the interest foregone from putting your money in FDs, in theory, you are getting a free ride to earn the other component – capital appreciation of the shares.

You have to take into account two things however. First, the dividend rate must be sustainable, otherwise the argument does not work. Second, unlike putting your money in FDs, both the principal and the return are at risk when you invest in shares.

Hence, the company you invest in must be able to earn recurring, or better still growing, returns. This helps ensure a sustainable dividend yield and capital appreciation of the stock over time.

Equally importantly, you must be comfortable that the management will not do something stupid to destroy the value of the company.

The strategy of buying into high dividend yielding stocks is very apt during economic downturns when interest rates are low or declining, and when the relatively high dividend yields provide downside protection for the stock.

Further, given that these stocks are often perceived to be very safe, they are likely to be re-rated first when the market turns.

High dividend yielding companies tend to have strong cash generating businesses, and they are often in somewhat matured industries such as tobacco, gaming and consumer.

By the same logic, companies in a high growth phase cannot afford to pay high dividends because their earnings have to be ploughed back into the business. This inability to pick high growth companies is one of the greatest flaws of the dividend yield model.

Another simple but useful measure of value is price to book, or P/B. It denotes what you are paying for the company in relation to the book value of its net assets.

Given that the value of assets in financial statements here is normally stated at historical costs, P/B is usually a conservative measure of what the company is worth.

As a general rule, a P/B of close to 1 (or lower) is considered attractive as you are investing in the company at almost the same cost as its original shareholders. The goodwill the management most likely has built in the business over the years e.g. a good brand name, strong distribution and good relationship with clients, comes for free.

Relying on P/B alone, however, is not adequate, as it does not tell you anything about the earnings generating and dividend paying ability – ultimately that is what matters to a shareholder.

So what if a company is trading at a P/B of 0.5x, if it never develops its assets to earn profits, or has no intention of selling those assets?

P/B is often used as a complementary measure to PE, serving as a value-screening device. On its own, a variation – price/market value (instead of historical cost) – is commonly used in the valuation of property development businesses, as it provides an indication of earnings generation potential beyond the immediate fiscal year.

This same measure is also commonly used for investment property and investment holding companies, but I personally feel the application is somewhat academic, unless the company intends to dispose its assets, or unless there is a possibility of someone buying over the company with the intention of disposing those assets.

It is also often used on a stand-alone basis for loss-making companies, where PEs are not applicable. Sometimes, even insolvent companies are worth something, as debts can be restructured or creditors may be asked to take a haircut. In such instances, asset-based measures are probably more useful than earnings-based ones.

Many variations of earnings-based measures have also been developed, in order to overcome some of the inherent flaws of the PE model.

For example, the PE being a single-period model, it treats every investment as if the risk is uniform and the contention that cash flow gives a better indication of returns from investments than earnings.

Hence the use of price to cash flow ratio, and its more sophisticated cousin, the discounted cash flow (DCF).

The latter’s much touted advantages are that it uses cash flows instead of earnings, it is a multi-period model, and that it recognises the time value of money and the unique risk of each investment.

Enterprise value (EV), a more recent phenomenon, measures the value of the business – funded by both shareholders and creditors as opposed to the value of the company – the portion of the capital funded only by the shareholders.

When used together with cash flow (denoted by earnings before interest, tax, depreciation & amortisation, or EBITDA in short), the EV/EBITDA ratio further develops on the payback concept of PE, but to both creditors and shareholders, not just the latter.

Finally, another increasingly used measure works on the concept of economic profit. The economic value add (EVA) recognises that there is a cost to capital, just like there is to debt, even though paying interest on debt is obligatory, while paying dividends is not.

Capital is never free because shareholders could have earned a return had they chosen to put their money elsewhere. EVA is calculated by charging a cost of capital to profits reported using the traditional accounting convention.

Beyond PE, dividend yield and P/B, most of the other measures discussed above usually have narrower applications in more specific industries, and are probably less suitable for retail investors because of their complexity.

Equipping yourself with a good understanding of the basic concepts of PE, dividend yield and P/B should suffice for a start, I believe.

(The above was extracted from Sahamas forum (a Malaysia forum site), on which I occasionally post. It is specifically taken from the "All About the PE Ratio" thread in the Investing Treasury Chest sub-forum.




Anonymous Anonymous said...

I found this stock ranking/screening web-based tool that you might find's the opposite of what your article talks about, but, I'm sure you'll agree that projected PE and PEG relative to the rest of the market are still important considerations...if so, I thought you might want to see this:

7/18/2008 11:00 AM  
Anonymous Penny Stock Newsletter said...

Valuing a stock can be very subjective.

11/24/2012 8:55 PM  

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