Investing in stocks is quite risky if we don't do proper analysis. Stock prices can go up and down at any time. Even sometimes prices can go very low without any clear reason.
One way to minimize the risk is by investing in mispriced stocks, i.e. stocks that are priced lower than their actual value (undervalued), rather than picking stocks only because of hype or positive trend. This strategy is often called value investing.
The term value investing was first introduced by Benjamin Graham (the mentor of arguably the most successful and well-known investor of all time, Warren Buffet) and David Dodd in the 1920s. By investing in an undervalued stock, we expect the price to return to its fair price one day, so we will be less worried when it goes down. A lower price can even become an opportunity for us to buy more.
Some Simple Valuation Methods Using Earnings
There are various methods to measure stock valuation. Some of the simpler ways are involving the company's earnings, such as:
1. PE Ratio
PE (Price to Earnings) Ratio is defined as a ratio of current stock price to its earnings per share (EPS). The lower the PE Ratio, the more undervalued the stock is. Personally, I often look for stocks with a PE Ratio between 0-15. I also consider a PE Ratio below 6 as undervalued. We can find PE Ratio data on many stock market platforms like Yahoo Finance or Wall Street Journal.
Note that a PE Ratio can be negative. It means the company is not profitable yet (negative earnings). In that case, the PE Ratio is irrelevant.
Example:
We will use Dell Technologies Inc. (ticker symbol DELL) as an example.
Using my standard, DELL can be considered a stock with a very good PE Ratio, and even almost undervalued.
2. Relative PE Ratio
Previously, we measured the valuation by just looking at the stock's PE Ratio and made assumptions on how good it is.
This relative PE Ratio method is slightly different. Here, we want to compare the PE Ratio to the others.
Example:
We know that DELL's PE Ratio is 6.10. Now we will look at HPQ and IBM, which run similar business.
The PE Ratios of IBM and HPQ are 21.41 and 5.75. This means, DELL is more undervalued compared to IBM, but more overvalued compared to HPQ. Another way to measure it is by looking at more competitors and taking the average PE Ratio of all those companies as a benchmark.
3. PEG Ratio
PEG Ratio is a ratio of current stock price to the company's earnings growth. Like PE Ratio, we look for a lower value. This method requires an assumption on the expected rate of earning growth. We can also use historical earning growth in the last few years to predict future growth.
Personally, I like to be a little bit more conservative by applying a 30% discount to historical growth. Below is the formula I use to calculate PEG. I consider a stock undervalued if its PEG ratio is between 0-1.
\begin{equation} PEG=\frac{PE\ Ratio}{Historical\ growth\ rate*0.7} \end{equation}
The average historical earning growth can be calculated using CAGR calculator by putting the initial and final EPS.
Example:
Currently, DELL has a 6.10 PE Ratio. We can then look at its income statement in Yahoo Finance to get the initial and final EPS for our growth rate calculation.
We can see that in 3 years (from 2018 to 2021), DELL's EPS has grown from 3.30 to 5.38. Putting those values in the CAGR calculator, we get the following growth rate.
Now, we will use this growth rate and the PE Ratio into my equation, we get the following PEG Ratio.
\begin{equation} PEG=\frac{6.10}{17.69*0.7}=0.49 \end{equation}
Based on the result, DELL is undervalued for me.
4. Eddy Elfenbein's Valuation
This method was published in his article: http://www.crossingwallstreet.com/archives/2012/05/worlds-simplest-stock-valuation-measure.html. It is quite interesting. Notice that in the previous valuation method using PEG, we have 1 issue. If the company's earnings were not growing, either 0 growth or negative growth, the method would be irrelevant.
Eddy Elfenbein's valuation formula can address this issue. He assumes we can buy a zero growth company at a PE Ratio of 8. Therefore, he proposed the following formula to calculate the fair PE Ratio.
\begin{equation} PE\ Ratio=\frac{Growth\ rate}{2}+8 \end{equation}
If we had zero or even negative earning growth, we could still have a positive PE Ratio.
In this method, after having the fair PE Ratio, we can then calculate the stock fair price by multiplying the PE Ratio to the expected next year EPS. Usually companies publish their earnings forecasts for the next year. We can use those values.
However, if for whatever reason we decided not to use the earnings forecasts, we can use the expected growth rate to calculate next year's EPS using this simple formula
\begin{equation} EPS=(1+Growth\ rate\ in\ decimal) * Current\ EPS \end{equation}
In summary, I will extend Eddy Elfenbein's formula as follows to get a stock fair price, in case we didn't use the company's released earnings forecast.
\begin{equation} Fair\ Price=(\frac{Growth\ rate}{2}+8)*(1+Growth\ rate\ in\ decimal) * Current\ EPS \end{equation}
Just like Eddy Elfenbein, I usually also look for stocks that are 30% below their fair price. This 30% value is often called Margin of Safety. This concept was popularized by Benjamin Graham.
Example:
We will use (17.69*0.7) of expected growth rate for DELL like the previous example.
Now let's say DELL released its earnings forecast for next year at 7.50. We will get the following PE Ratio.
\begin{equation} PE\ Ratio=\frac{17.69*0.7}{2}+8=14.1915 \end{equation}
Multiplying it to the earning forecast, we get:
\begin{equation} Fair\ Price=14.1915*7.05=100.05 \end{equation}
Then, after adding a margin of safety of 30%, we get 70.03. That means the current price of DELL, 41.43, is way undervalued based on this method.
As for alternative, we will calculate using my equation. Recall the previous data from Yahoo Finance, we know DELL's EPS (TTM) is 6.79. Plugging those values into the equation will give us:
\begin{equation} Fair\ Price=(\frac{17.69*0.7}{2}+8)*(1+(0.1769*0.7)) * 6.79=108.2925 \end{equation}
After adding a margin of safety of 30%, we get 75.80.
Conclusion
Those are some relatively simple methods we can use to measure stock value. You can combine all of those methods for better insight. There are a lot of other valuation methods we can use. Some of the most popular ones are Discounted Cash Flow (DCF) method, Peter Lynch's valuation method, and also Dividend Discount Model (DDM), which are a little bit more complex than the above methods.
Please also remember that a good stock is not only determined by its valuation. There are a lot of things we must consider, like how the business is run, the competitors, the dividend, the cash flow, and many others. But, understanding the valuation can at least prevent us from investing in overvalued stocks, which have more possibility to go down towards their fair price.
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