Market Beat: Measuring a stock’s valuation
Legendary investor Warren Buffet once said, “Price is what you pay. Value is what you get.”
Two major styles of investing are known as growth and value. Growth investors seek companies who are rapidly growing their earnings and profits. Value-oriented investors search for stocks who are trading at a reasonable valuation relative to their peers.
There are several common metrics for measuring a stock’s valuation. One of the most common is the price to earnings ratio, in which the price of the stock is divided by the company’s earnings — the lower the number, the better for value investors.
Another is the price-to-book ratio, in which you calculate the book value of the stock, then divide the book value by the price.
If a stock you were analyzing has a price-to-book ratio of one, that would mean that the company is trading at its book value. A ratio of two would mean that it is trading at twice its book value.
If it were to be trading at a ratio less than one, that would indicate that the current price is actually less than the company has invested in itself.
You can get some good insight into a company’s business by analyzing its cash flow. It’s pretty tough to stay in business these days without cash flow.
One metric used is the price-to-cash flow, in which you divide the company’s price by its cash flow. Another measure of cash flow is known as free cash flow.
To obtain the free cash flow, you subtract the company’s capital expenditures from its operating cash flow to determine how much free cash it has available to work with.
A good measure of a company’s valuation is known as the price-to-free cash flow ratio. To get that number, we divide the price of the stock by the free cash flow.
For the price of the stock, you don’t use the price per share; you use the market capitalization of the company, which is the total value of the company and is obtained by taking the price per share of the stock and multiplying it by the number of shares outstanding.
A lower number here can mean that the stock is trading at a reasonable value. When comparing stocks, you should also compare the valuations to the average for that industry.
Value investing requires discipline and patience. Warren Buffet also said, “Someone is sitting in the shade today because someone planted a tree a long time ago.”
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.