While calculating P/E ratio using trailing earnings, investors should take care to avoid differences in accounting methods by different companies
By P Saravanan & Alok Pandey
As the Indian equity markets hit new highs every day, it is essential for an investor to understand fair valuation of stock prices. The methodologies used to estimate the value of an equity share are largely accounting approach and discounted cash flow approach.
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Through these methods one can assess the intrinsic value of a share and compare it with the market to know whether the share price is undervalued or overvalued. Relative valuation approach is also an important method often used by the investors to ascertain the intrinsic value. Let us discuss the same in detail.
Concept of relative valuation
The concept of relative valuation belongs to most modern approaches. Under this, value of a share is derived from the pricing of comparable companies using certain established metrics such as price earnings ratio, price to book value, price to cash flow and the like.
The significant feature of this approach is that it provides us information as to how the market is currently valuing stocks at several levels such as aggregate market, level, industry level and company level within the industry.
Further, it helps to convert the values of companies sharing similar characteristics to comparable multiples and then to check how those firms stand in relation to their peers.
In discounted cash flow valuation, value of the share is derived according to its capacity to generate cash flows in the future. Whereas, in relative valuation, we are making a judgment call on how much a firm is worth by looking at what the market is paying for similar companies.
Using the price multiples
Investors should use various prices multiples such as the P/E multiple (the price per share divided by the earnings per share), the P/CF multiple (price per share divided by cash flow per share, that is nothing but the earnings per share plus the dividends per share), P/BV (price of share divided by book value) and P/S (price to sales) to value shares.
Among all, the most commonly used multiple is the average of P/E ratio of comparable firms and which is popularly known as the P/E multiple. By multiplying this average P/E ratio by the expected earnings of the company we can get the estimate of its share price.
There are two variants of P/E and they are called trailing P/E and leading P/E. The trailing P/E, also called current P/E, is computed by considering the current market price of the stock divided by the most recent four quarters’ earnings per share. The earnings per share in such calculations are called trailing twelve months (TTM) EPS. The leading P/E is also known as the forward P/E or the prospective P/E and is calculated by dividing the current share price by next year’s expected earnings. While calculating a P/E ratio using trailing earnings, investors should take utmost care to avoid differences in accounting methods by different companies. Care should also be taken to avoid transitory, nonrecurring components of earnings that are company-specific or cyclical in nature.
To conclude, relative valuation is definitely a value addition over and above the existing discounted cash flow techniques.
Relative valuation is definitely a value addition over and above existing discounted cash flow techniques.
It helps to convert the values of companies sharing similar characteristics to comparable multiples and then check how those firms compare to peers.
Investors should use prices multiples such as P/E multiple, P/CF multiple, P/BV and P/S to value shares.
By multiplying average P/E ratio by the expected earnings of the company we can get the estimate of its share price.
P. Saravanan is a professor of finance & accounting, IIM Tiruchirappalli. Alok Pandey is chairman, Index Advisory Committee, MCX