COMPARABLE COMPANY VALUATION
COMPARABLE COMPANY VALUATION
Comparable company valuation is one of the most important ways to value a company by comparing it to similar companies. While each company has its own independent pros and cons, comparing the metrics and ratios of a stock to its competitors can help you determine whether the stock is undervalued or overvalued. You can calculate comparable company valuation by Using Metrics, Ratios, The PEG Ratio, or Intrinsic Value.
Metrics other than ratios can be useful when evaluating a stock. Metrics provide numerical financial data that can be analyzed over time and in comparison with other stocks. When valuing a company, the most important ones are growth metrics:
Revenue Growth - calculated Quarterly Year-over-Year (YoY)
Earnings Growth - calculated Quarterly Year-over-Year (YoY)
The reason why this is important is that if revenues grow, earnings often grow, and if earnings grow, the earnings per share increase and lowers the P/E (Price/Earnings) in the future which forces the price to go up and your stocks are then worth more.
Ratios are a useful way of gauging a company’s health and comparing the opportunities and risks associated with making an investment. It is important to keep in mind that ratios are not meant to be the end-all, be-all when examining companies, but instead give you small pieces of the bigger picture.
Profitability Ratios are often more important than total revenue. Just because a company has a high revenue stream does not mean that it will have high profits. Revenue shows how much money a company is taking in from sales, and profitability shows how much money is left over to help the company grow or pay dividends. Here are some common profitability ratios that can help you gauge how likely a company is to turn a profit:
Profit Margin = Net Income / Revenue
Operating Margin = Operation Income / Net Sales
Solvency ratios give a picture of the long-term financial health of the company. They can also show the ability of the company to develop future assets. This is particularly important for investors to examine because it shows how much of a company’s assets were purchased with debt that will have to be repaid. It is also important to remember that younger companies are going to have higher debts because of upstart costs, which are usually funded through debt.
Total Debt To Total Assets = (Short Term Debt + Long Term Debt) /Total Assets
Liquidity ratios measure how quickly an organization’s assets can become cash. This is important because it gives you an idea of how effective the company is at raising cash to invest in new assets and it also indicates how easily the company can collect on its credit account.
Investing in a company that has a hard time raising cash can spell trouble because the company will be less able to invest for future growth. Some common liquidity ratios that can help explain this concept are as follows:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Current Ratio = Current Assets / Current Liabilities
Working Capital Turnover = Revenues / Working Capital
Valuation ratios are used to analyze the attractiveness of investing in various companies. These ratios provide a comparison of what a company’s stock is selling for compared to what the company is worth. In general, investors are looking for the lowest valuation ratios to find the best “deal” possible.
Price to Earnings (P/E) = Market Value per Share/Earnings per Share (EPS)
Price to Book (P/B) = Stock Price / (Total Assets - Intangible Assets and Liabilities)
Price-to-Cash Flow = Share Price / Cash Flow per Share
Price to Sales (P/S) = Price / Revenue per share for the last 12 months
Intrinsic value is the quantitative and qualitative value of the company. While ratios and numbers tell the quantitative story, there are other important soft factors that cannot be precisely measured, such as management quality and customer loyalty.
Berkshire Hathaway, the nest egg of Warren Buffet. While Berkshire’s numbers are impressive, what also makes the company valuable is that it has some of the best managers and the best products in the world. Leadership, structure, and other qualitative aspects can be hard to put a number on, but they are important to consider when evaluating a company.
USING THE PEG RATIO
By mixing P/E with earnings growth, we arrive at the useful ratio called Price-Earnings-Growth (PEG) ratio and it is the quickest way to screen if a stock is under or overvalued.
Google is currently trading at a P/E of 29, compared to Apple which has a P/E of 13. By only looking at P/E, one would say that Google is overvalued. If you look at all the other ratios such as P/B, P/S you'll see that Google is still valued higher than Apple. Here is where growth metrics becomes useful. Google is growing its quarterly revenue Year-over-Year by 12% and it's earnings by 37%, compared to Apple who's growing it's revenue at a 4% pace and actually shrinking its earnings by 8%. Conclusion: IF Google's earnings continue growing at the rate of 37% per year, their PE will be 37% lower next year unless the price goes up and it will take less than 3 years for Google to be undervalued compared to Apple.