How to value shares – using different ratios to improve your analysis

Fear of missing out is a common worry among investors, particularly in a buoyant market. Watching share prices rise from the sidelines is a tough pill to swallow and can leave some investors feeling like they’ve missed the boat.

Taking a long-term view means you don’t have to focus on little known companies to find mispriced opportunities. If you use the right tools, sometimes it’s possible to find undervalued stocks among some of the biggest names on the market.

Looking at a company’s valuation is crucial once you’ve got a potential investment in mind. But that’s not to say that scanning a few ratios is enough to develop a fully-fledged investment thesis. Understanding the underlying company and the risks it carries is an important step.

This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Price to earnings (PE)

Perhaps the most well-known measure of valuation is the price to earnings ratio. It tells you how much investors are willing to pay for every pound of profit a company delivers. Generally, the higher the number the more valuable the market thinks the company is.

One way to use PE ratios is to compare a company’s current PE ratio to its long-term average. If shares change hands significantly above the long-term average, it tells you the market has high hopes for the company. This can sometimes cause volatility if the company doesn’t deliver on investors’ expectations.

It can also make sense to use the PE ratio to compare similar companies within the same industry. Comparing an energy stock to tech shares won’t tell you much about how the market rates it. But comparing two energy stocks will tell you which company could offer better value.

Take the below example.

Even though Company B’s shares are more expensive, they’re better value. You’re paying less for each pound of profits.

Solving the growth dilemma – PEG ratios

For profitable companies, the PE ratio tends to be the first port of call for valuation. However, it doesn’t always tell the whole story.

In the above example, imagine that Company A is a cloud computing business, while Company B makes personal computers. Both are in the tech industry, sure, but cloud computing is expected to grow exponentially over the next decade.

This is where the PEG (or Price/Earnings/Growth) ratio comes into play.

To work it out, divide the PE ratio by the company’s estimated annual growth rate. A lower PEG ratio usually represents a more attractive stock. It levels the playing field for high-growth companies and makes it easier to compare those growing at different rates.

For UK businesses, you can usually find PEG ratios on company factsheets on our website.

Taking growth into account, Company A now looks like the better pick.

Investors should bear in mind that PEG ratios are based on growth estimates, which don’t always hold up. As an investor, you need to look at those growth assumptions and decide for yourself if you think they’re reasonable.

What about dividends? – PEGY

Growth stocks aren’t the only ones that can get unfairly punished by PE ratios. The benefit of a dividend-paying stock also gets muddled in the calculation. For that, we have the PEGY ratio, which includes both earnings growth and dividend yield.

PEGY = PE ratio/(% earnings per share (EPS) growth + % dividend yield)

A growth stock reinvests most of its profits to fuel future growth, accounted for in the PEG ratio. However, an income stock could have a lower growth rate because part of those profits are distributed to shareholders.

The PEGY ratio takes this into account by adding in the dividend yield. It’s a useful way to compare the price of growth and income stocks.

Looking again at the above example, imagine that Company B also offers a 4% dividend yield.

A lower PEGY ratio shows a company that might be better value. In this case, Company B now has a slight edge. Like the PEG ratio, the PEGY ratio has its drawbacks – not only does it rely on future growth estimates, but dividends aren’t guaranteed and could be cut at any time.

Thinking outside the PE box

The last couple of years have made using these types of PE ratios to value stocks even trickier due to the pandemic. Covid-19 restrictions meant for many companies, the ‘earnings’ side of the equation suffered a large, but likely temporary, decline. In these cases, it can make sense to compare the stock price using other business metrics.

Price to book (PB)

Another way to value a company is by its book value, or the value of its assets minus liabilities. Book value tells you how much a company would be worth if it were liquidated today – at least in theory.

Most think a PB ratio over much more than one can signal a company is overvalued – it suggests investors are paying more than the underlying business is worth.

Intangible assets, things like patents and intellectual property, can change the picture. There’s an element of intangible value to every business and the more intangible value a company has, the less relevant the magic number of one becomes.

The PB ratio is typically used for businesses with lots of assets, like airlines and manufacturers. Generally, the lower the PB ratio, the more attractive the shares look to value-seeking investors.

Price to sales (PS)

For tech and service companies that don’t have balance sheets laden with machinery and property, PB ratios aren’t as useful. For businesses in this category, we think it makes sense to compare the share price to sales instead. The PS ratio tells you how much investors are willing to pay for each pound’s worth of revenue.

PS ratios also work for companies that aren’t profitable yet. In these cases, the ‘earnings’ part of the equation is negative, so the PE ratio doesn’t tell you much. This is sometimes the case for companies about to float shares on the stock market, or high-growth companies that reinvest all their profits in the name of rapid expansion.

As they say, sales are vanity, profits are sanity and cash is king – ultimately it should be profits and cashflow that matter to investors. A company with a low price to sales ratio, but with little or no hope of ever turning a profit, is not a bargain.

Don’t get caught in a value trap

Valuation metrics like these are useful when it comes to comparing stocks, but they shouldn’t be used on their own. A low valuation ratio could signal good value, but it could also be a red flag. The market usually has a good reason not to be excited about a particular stock – it might be wrong of course, but it’s rarely miles off. Industry developments, macro trends and company-specific issues should all be factored in.

Our share research team can get you one step closer to making more informed investment decisions. We break down company statements and find emerging trends on over 100 stocks. Get our Share Insight email delivered weekly to your inbox to stay on top of the market’s developments.

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