Fundamental Valuation in Investing Part 2

Check out Part 1 HERE

Return on Equity (ROE)

Return of Equity or ROE is one of the ratio-based approaches in stock valuation. It is a measure of how well a company generates profits from its shareholders’ investments in the company or simply the ratio of net profit to shareholders’ equity, ROE is generally calculated over a year and expressed as a percentage and an important indicator of how effective management is at using equity financing to fund operations and grow the company.

valuation ROE

In accessing how well a company was doing, investors would check it’s average 5 years ROE to be greater than 10%, however, this ratio alone shouldn’t be used to classify individual stock, as a company with high level of debt will also have a high ROE. Meaning that they may not show much on return on total assets, thus ROE is looked along with a company liabilities or debt.

 

 

Price to Book (P/B Ratio)

Price to Book or P/B ratio gives some idea to investors, whether the stock they are paying is under or over-valued. Generally Ratios of 1 or lower, mean that the company is trading below what it’s worth on paper while that Ratios of 1 or higher, mean the company is trading above what it’s worth on paper.

 valuation PB

Investors would check against another valuation ratio as lower P/B value does not necessary means that a company is fundamentally strong and solid, it could be what left off from a company that’s heading bankruptcy, while a company with higher P/B ratio could have a potential to grow and make more money. This showed that the idea of P/B ratio does not factor in the future prospect of a company, but simply represented by a company’s worth or book value on paper and its share price.

Price to Earnings (P/E ratio)

Another commonly used ratio is the Price to Earnings or P/E ratio, P/E ratio focuses on one of the primary drivers of an investment’s value that is the earnings of the company. It is computed by dividing the stock price to the EPS value, P/E ratio change constantly when a large price change in a stock, or if the EPS change.

valuation PE

A ratio of 0 to 10 is low and would point to an undervalued stock, a company in decline or a company that experiences abnormally high earnings. Ratios between 10 and 17 are ideal and tell an investor that the stock is fairly priced. Ratios above 17 are signs that the company is either overvalued, had very low earnings for the year or is expected to grow. But it is usually not enough to look at just the P/E ratio, it does not tell us all we need to know of one company and determine its status. As looking at just the P/E ratio alone would make high-growth companies seem overvalued relative to others.

 

PE to Growth (PEG ratio)

PE to Growth is another ratio to gauge a stock whether a stock is worth investing, it compares P/E to the company’s revenue growth, which gives a good picture of the rate at which companies have been able to expand their businesses. PEG is a widely employed indicator of a stock’s possible true value as it accounts for the growth of a company. The P/E ratio used in the calculation are forward or trailing.

 valuation PEG

The ratio offers suggestion whether a company’s high P/E ratio reflects a high stock price or is a reflection of promising growth prospects for the company. The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, while a lower PEG means that the stock is undervalued more; Be it forward or trailing PEG, it is up to due diligence of an investor to the risk of a low PEG ratio stock, an investor would forecast a company’s PEG value and make sure that it is not artificially low.

 

Margin of safety

The Margin of safety is the amount by which a company’s shares are trading below their intrinsic value or a discount of the price below intrinsic value. As the intrinsic value of one company is difficult to compute accurately, the margin of safety thus gives some cushion that protects the investor from poor decisions and during the downturn in the market.

valuation MOS

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. Commonly a safety margin of at least 20% is desirable for a high-quality stock.  However, a higher margin of safety up to a 50% are accounted for a more speculative stock and during a downfall of the market.

 

Piece of Advice

When it comes to making money by investment, there are so many ways to do it. All of the famous investors apply their own unique method to the analysis and the investment process. Many have tried to reproduce the techniques or process used by the famous investors, unfortunately, they have failed. Bear in mind that this isn’t something that you or I can copy 100%, there’re many other factors in play, which is why there can only be one Warren Buffett.

However, I can tell you that there is one thing that all the famous investors have in common.

“Don’t Lose Money.”

The pros could all make money in contradictory ways because they all know how to control their losses. They would diversify adequately and invest with a margin of safety. And often they would not stay long in a losing position whereby it would corrode their overall portfolio. Beside to not lose money, there’s another known secret in successful investing

“Buy low and sell high”

In fact, most of the investors failed to make money is because they are doing the opposite. Why is that? Because they do not do their own research, let alone fundamental analysis, and they follow ‘tips’. You must avoid such mistake! By first understanding the principles and fundamentals of investing, we’d have got a clear picture of how a company’s stock was doing, and if it is under or overpriced. This we could avoid paying a premium for a highly priced stock.

Again, it is back to the 2 simple rules.

 “Rule No. 1: Never lose money. & Rule No. 2: Never forget rule No.1”

Apply these rules and take responsibility for your own decisions and investments, and you’ll benefit and grow as a successful investor.