3 Things to note in Valuations of Stocks.
November 22nd, 2008 by ALVIN SOONG
There are 3 things to note in the recent valuation of stocks given the fact that price is at firesale now:
1) PE ratio
To work out a stock’s PE, take its share price and divide that by the earnings per share (EPS) of the company. PE ratios is useful only if it is positive (It becomes meaningless when companies go into the red and the denominators used to determine these ratios - earnings - turn negative.)
For example, if you look at Singapore Airlines (SIA), as at Nov 11, when it was trading at $11.42 a share, its PE was 7.5 times or 7.5x. But what does this figure tell you? Is SIA’s stock cheap or expensive? To get a better perspective, you can compare SIA’s PE against the market PE. On Nov 11, the benchmark Straits Times Index (STI) was trading at a PE of 8.9x. This essentially means that SIA’s stock was cheaper than the overall market at that point.
2) PB ratio
However if the sub-prime crisis has left many banks and financial institutions in the United States with negative earnings, and thus negative PE levels. We have to use PB ratios to gauge the value of the stocks that you’re considering.
To work out a stock’s PB, take its share price and divide that by the book value of the company. A firm’s book value is the value of its assets as expressed on its balance sheet, and provides an estimate of how much the firm would be worth if it had to be liquidated. A stock’s PB indicates how much the company’s shareholders are paying for its net assets - and as with PEs, the lower the figure, the cheaper the stock. If a stock’s PB is 1x, then the share price is exactly what the company would be worth per share if all its assets had to be stripped off and sold.
PB ratios also work better for certain industries. Take banks for instance. Most of their assets are loans extended to borrowers - a relatively homogenous business model across the industry. PB ratios provide a better measure of what bank stocks are worth because loans are rarely valued above their historical costs.
3) ‘Value trap’
Some stocks and markets could turn out to be a ‘value trap’. This means that they are attractively valued but still prove disappointing at the end of the day.
Various reasons could include: a particular market could be suffering from political uncertainty; a company could be facing depressed earnings without any prospects for a near-term turnaround. Such markets or stocks could stay cheap for a long time.
An example would be a country market with a low PE that had been relying on electronics exports for a long time. If consumer demand for technology turned sluggish and looked likely to remain so over the medium to long term, such a market could take a long time to recover unless the country decided to diversify into other growth sectors.
And I think it takes patience more than guts. You must have faith that equity markets will recover eventually and the patience to wait till they do.
Extracted from Sunday Straits Times 16th Nov 2008
