There is a saying that you don’t judge a stock by its market price.
Many first-time investors make the mistake of evaluating a stock whether it is cheap or expensive by simply looking at the share price.
For example, a stock may be perceived expensive when its share price is trading at over a thousand pesos per share while a stock may be considered cheap when it is selling at less than one peso per share only.
Similarly, a stock may be considered a bargain when its share price has fallen by over 20 percent as compared to a stock seen as overpriced, whose share price has increased by the same percentage.
The tendency to evaluate the worth of a stock based on share price alone can be risky because there are other factors that determine the inherent value of a stock.
These factors can be growth prospects of the stock in terms of sales and income. It can also be growth in assets of the company, as well as returns on investment.
When you buy a stock, you want to make sure that you are paying the right price based on your estimated value of the stock.
A stock that trades at less than one peso may not be necessarily cheap if its market price is trading above its fair value.
Likewise, a stock that sells at over a thousand peso may not be that expensive at all if it is trading at 50-percent discount to its fair value.
So how do you estimate the fair value of a stock? Here are the five simple ratios every investor must know when buying and selling in the stock market:
1. Price-to-Earnings (P/E) ratio
The price-to-earnings ratio, also known as the P/E ratio, is the most common valuation metric used by investors and market professionals.
The P/E ratio is computed by simply dividing the share price of the stock by its earnings per share. For example, the P/E ratio of Meralco at 18x is determined by dividing its current share price of Php330 per share by its earnings per share of Php18.17 per share.
The P/E ratio indicates how much the market is willing to pay for every peso of earnings. As an investor, you would want to pay less for the same return as much as possible.
If you are looking to buy stocks at reasonable valuation, you can compare stocks based on P/E ratios. A stock may be considered relatively cheap if it has a lower P/E ratio compared to the industry or market average P/E.
Bear in mind, however, because not all stocks have the same growth outlook, some stocks that may appear cheap actually deserve to trade at low P/E because of low earnings growth.
P/E ratios are a useful tool in identifying potential value stocks, but it is the growth potential of the company that determines the inherent value of the stock.
2. Price-to-Book Value (P/B) Ratio
If the P/E ratio relates to the earnings of the company, the P/B ratio or price-to-book value ratio relates to the net asset of the company.
The P/B ratio indicates how much the market is willing to pay for every peso at book value of net asset of the company. The P/B ratio is computed by dividing the market price of the stock with the book value per share. The book value of the company is what remains when all liabilities and payables are deducted from its total assets.
For example, if the total assets of Globe Telecom, which stands at Php269 billion, will be reduced by its total liabilities of Php202 billion, its total net asset would be Php67 billion or Php504 per share.
The P/B ratio of Globe is then computed by simply dividing its current stock price of Php1,760 by its book value per share of Php504 to get 3.5x ratio.
Similar to P/E ratios, a stock with relatively low P/B ratio indicates that the stock may be undervalued. But, again, some stocks deserve to trade at low P/B ratio due to lack of sustainable growth.
For example, PLDT has a lower P/B ratio of 3.2x compared to Globe’s 3.5x because PLDT has a lower average return on equity of 18 percent versus 26 percent return of Globe.
When comparing P/B ratios, it is important to validate the ratios with actual growth in equity of the companies.
3. Price to Sales (P/S) ratio
Another valuation metric similar to P/E and P/B ratios is the P/S or price-to-sales ratio. Instead of measuring earnings or book value, this ratio focuses on sales of the company.
The P/S ratio indicates how much the market is willing to pay for every peso of sales that the company generates. The P/S ratio is computed by simply dividing the market price of a stock with sales per share.
Some investors consider the P/S ratio as a more reliable indicator compared to P/E ratio because sales are harder to manipulate compared to earnings. Others use P/S ratios to compare promising stocks that are not yet profitable.
Similar to P/E and P/B ratios, not all stocks with low P/S ratio are good candidates for investment. Some stocks trade with low P/S ratio because they have lower net profit margins.
For example, Jollibee has lower P/S ratio of 2.4x compared to SM Prime’s 11x, but if you look at the net profit margins of Jollibee, it also has lower net profit margins of 5.4 percent compared to SM Prime’s 31.5 percent.
4. Price-to-Earnings to Growth (PEG) Ratio
The price-to-earnings to growth ratio, or PEG ratio for short, has been a popular valuation tool by market professionals in recent years.
The PEG ratio is computed by dividing a stock’s P/E ratio with expected growth rate in earnings. For example, the P/E ratio of BDO Unibank at 23.9x may look more expensive than the Bank of Philippine Islands’ P/E ratio of 21x.
But earnings growth of BDO at 15.6 percent is higher compared to BPI’s growth estimate of 10.7 percent, so the PEG ratio of BDO at 1.53x will come out cheaper than BPI’s PEG ratio of 1.95x.
5. Debt to Equity (D/E) Ratio
While an increase in expected earnings may boost the price of a stock, as well as its price multiples, it is important that you also evaluate how the company behind the stock is financing its growth.
Using the latest balance sheet of the company, you can compute the debt-to-equity ratio by dividing its total debt with total shareholders’ equity. The ratio will show how much risk the company is taking in expanding the business.
A low debt-to-equity ratio means that the company is conservative, taking a low risk approach in financing its growth by borrowing less and using more of internal funds or shareholders’ money. A high debt-to-equity ratio, on the other hand, means the company is taking a more aggressive and riskier route in growing the business by using other people’s money.
The use of debt-to-equity ratio can help you identify companies that may pose a higher risk of financial distress in the future. Investors normally compare debt-to-equity ratios of stocks against industry averages.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888