Share valuation

How should you value shares? Attempts to answer this question have spawned an entire industry and a substantial body of academic research.

The most popular set of tools for valuing shares is a group of ratios that compare a company’s share price to various measures of its financial health, such as earnings, book value and dividend. The most popular is the price-to-earnings ratio, or p/e.

What is a p/e ratio?

It is simply the share price divided by the company’s earnings per share, defined as profits after tax. There are two types of p/e ratio: the first is based on the company’s most recently published profit and loss account, and has the advantage that it is derived from a “real” number – the profit a company actually made in its most recent accounting period. This is the p/e ratio listed in the back pages of the Companies & Markets section in the Financial Times. The more commonly used measure is the forward p/e ratio, which is normally lower and is based on a forecast of a company’s next profits announcement.

Why is the forward p/e ratio more widely used?

Investors are more interested in a company’s future than its past. A forward p/e ratio will usually be based on the average of all available analysts’ forecasts for upcoming profits, but an individual analyst can come up with his or her own p/e ratio. This is one way of finding an undervalued stock – if your p/e ratio for a company is lower than the consensus figure, the stock looks attractive.

What p/e ratio represents good value?

It depends on the company. A high p/e ratio is justified if you think the company will have a high level of earnings growth in the coming years – this type of company is known as a growth stock. For example, the average p/e ratio for technology stocks on the London Stock Exchange is 24.6. Oil and gas stocks, which are expected to experience lower earnings growth, are on an average p/e of 12.3. For all companies, a lower p/e ratio means the shares are cheaper, though not necessarily better value.

What other measures are there?

Another popular one is the dividend yield, the total value of dividends a company pays in a year expressed as a percentage of the share price. This measure is important if you are a value investor – one who looks for companies that are considered the opposite of growth stocks as they tend to have lower p/e ratios but also less exciting growth prospects. The higher the dividend yield, the cheaper the company. The yield is important if you are relying on shares to generate income.

Any others?

The third of the big three measures is the price-to-book ratio, which compares the share price to a company’s book value. This is the value of the company’s assets, less the value of its debts. Again, it tends to be more important to value investors. The ratio is normally above one, signalling that you are paying more for a company than its net assets are worth. Most companies are worth more than the sum of their parts because if their assets are well managed they create additional value over time. A ratio of below one does not necessarily signal a bargain because in practice you cannot necessarily sell a company’s assets for the value attributed to them in the company accounts – and even if you do, there are selling expenses.

Do these three measures apply to all companies?

No – they are generally not a useful way of valuing start-ups or companies in a distressed state, because you cannot compare the share price to profits or dividends if a company is not making profits or paying dividends. In theory, every company has a price-to-book ratio, but even this is not considered meaningful for companies with few assets but good prospects.

So how can you measure the value of these types of companies?

One framework that analysts use is a dividend discount model, based on the concept that any company worth investing in will start paying dividends sooner or later. Based on your analysis of a company’s prospects and business plan, you make some assumptions about these dividends – for example, you could assume that a company will pay its first dividend in 2009 at 5p a share, and that the dividend will then rise 20 per cent a year until 2012, then by 10 per cent a year thereafter. The share price tells you how much investors are prepared to pay today for the prospect of receiving those dividends in future – it is then up to you to decide whether this is a price worth paying, bearing in mind that the dividends could turn out to be a lot smaller, or bigger, than expected.

Do all these measures matter?

They are not the only way of deciding whether to buy shares, but they are the framework that most professional analysts use. At the height of the dotcom boom in 1999 and 2001, proponents of the “new economy” argued that measures such as p/e ratios were relics of the “old economy”, and people who applied them to profitless dotcom stocks didn’t “get it”. They evolved their own wacky measures, such as “price-to-click ratio”, which measured how much you were paying to own a share of popular websites. Many of the dotcom companies that floated in that era no longer exist. Today, the price-to-click ratio is gone, but the risk of investment bubbles remains, and if someone tells you that you can ignore a stock’s p/e ratio or other fundamental measures, your suspicions should be raised.