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07 Feb | Investment Valuation Ratios

This week, Investor Trader invited Graeme Pietersz from Money Terms to share some of his experience in choosing which ratios to use when valuing different investments.

A novice investor can often ask the wrong question about how to value shares, looking for one ratio to rule them all. Unfortunately, many articles on the subject do answer this question, and promote one particular valuation method: sometimes a simple ratio, sometimes something a bit more complex.

The right question to ask is “which valuation method is appropriate in the circumstances?”. What you use depends on what your strategy is and what sectors you are looking at.

The simplest choice for value investors is the PE ratio. It is easy to use and is available from many sources, so you often do not even need calculate it for yourself. The biggest problem is that this is a very basic number that is easily distorted by one off events, or by deliberate manipulation. This means that it is mostly useful for initial screening: to produce a list of companies worth analysing further.

For actual valuation it is better to rely on a PE based adjusted, usually forecast, earnings, or on a long term average. A PE based on the average of several past years of historical earnings uses certain numbers and averages out the effect of fluctuations. You still need to do more analysis of the company and its business to be sure that the earnings are sustainable. Many of the most value focused investors look for companies that are sheltered from competition by barriers to entry in their market — Warren Buffet tactfully calls barriers “moats”. This is something worth looking for in growth stocks as well: if you can keep competition out, you do not have to worry too much about maintaining markets.

The PE is also not applicable to all industries. It is fairly obvious that investment trusts, and other types of listed investment vehicle, need to be valued at the the value of their investments, not the value of the income generated. It is usual to use net assets per share. The same applies to other companies that are essentially a way of holding assets, such as property companies.

This also applies in less obvious cases, such as mining companies. They are more complex because the value is a combination of the value of assets (reserves in the ground) and the ability to exploit and expand these assets. A number of methods are used including PE, asset values with extraction costs deducted, and a weighted average of both.

In these cases the asset values that matter are the market values of the assets. In most sectors it is more practicable to look at book values. This is, like a simple PE, a number that can be heavily distorted and is best used for initial screening.

For very capital intensive companies Tobin’s Q (market value of debt plus equity divided by replacement cost of assets) may be useful, but it is generally best used as an indicator of whether the market is over or under-valued.

There are a number profit and cash-flow based ratios that are alternatives to the PE. The best known of these is EV/EBITDA which removes distortions causes by company history and accounting decisions, and allows fairer comparisons of companies with very different levels of debt. This comes at the cost of greater complexity, and more subjective decisions with regard to subsidiaries and associate companies.

There are also a number ratios related to EV/EBITDA, such a EV/EBIT, which reduce complexity, but fail to remove all the distortions. There are also cash flow based multiples such as price over cash flow per share, but these need care because cash flow can be volatile.

Cash flows are what ultimately matters: how much spending money the company can make for its shareholders. From this point of view, the best valuation technique is a discounted cash flow (DCF). It is often not worth bothering as the uncertainties around a DCF (about discount rates and forecasts) mean that a simple ratio will tell you as much: and if the decision to buy is so finely balanced as to require a DCF, you should probably carry on looking for better bargains.

Graeme Pietersz has worked as both a buy-side and a sell-side analyst, in the UK and Asia and has two postgraduate degrees in business and finance. Graeme’s Money Terms is the standard for financial definitions on the web.

Check out some of Graeme’s writing on all manner of topics at his blog or follow him on Twitter, I do – Ed.

Graeme Pietersz