Fundamental analysis 101: Two ways to value a company

Julie Brownlee, Fsp Invest, 18 Feb. 2014

Tags: valuation, investing, price earnings ratio, pe ratio, pe, sum of parts valuation, how to value a company, valuation, financial ratio, fundamental analysis, how to value a company, buying shares, investor, investment

When it comes to delving deeper into a company you’re interested in, you need to have a look at the value of the company. This can give you an indication if the company is trading at a discount or a premium to its current share price. So how can you do this? Read on to discover two different ways you can value a company…

Valuation is key when you’re buying shares on the stock market, the team at Money Week explain…

Here are two ways you can value a company…

#1: The price earnings (PE) ratio

The price earnings (PE) ratio is a quick way to judge whether a firm’s shares are cheap (low PE) or expensive (high).

The ratio compares the current share price to one year’s earnings. The earnings are either the last year’s (a ‘historic’ PE) or a prediction for the next 12 months (the ‘forward’ PE).

Let’s look at an example. If a firm has a share price of R5 and the last earnings per share (EPS) figure is 50c (EPS is just the annual profit divided by the number of shares in issue), then the PE is ten.

In other words, investors are willing to pay ten times one year’s earnings for the share. The higher the number, the higher investors think future earnings will be. This is because as earnings grow, this payback period shortens.

So rapidly growing companies (such as tech firms) tend to trade on higher PEs, whereas analysts expect companies with slow or no growth trade on low PEs.

High and rising PEs generally suggest investors are becoming more bullish. Like any ratio, you shouldn’t use the PE alone. The EPS number is subjective. And the PE also falls down if there are no earnings.

#2: The sum-of-parts valuation

Quite often a company has a number of different underlying businesses that combine to make up its overall profits. This can make valuing the company with simple measures, such as the price earnings (PE) ratio, misleading.

That’s because one or more of the underlying businesses can have a much greater influence on the overall performance of a company than the others. This in turn might make a share look more expensive or cheaper than it really is.

For example, a division that is relatively insignificant and neglected in the context of a large conglomerate might be worth a lot more to a different owner.

To account for this, analysts sometimes value each underlying business separately, based on measures such as profits or assets. They then add all the valuations together to get the sum of all its parts, then take away liabilities, such as debt, to get a total estimated value for the company.

Of course, investors may not recognise this value in the company’s existing form, but this valuation method can be a good way of spotting bargains, or firms that could be broken up.

So there you have it, two ways to value a company.

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