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Revisiting Valuation Metrics
Education | 11 December 2009
By: jason.liew
Articles (66) Profile

With 2009 coming to a close, it is perhaps a good time to refresh your understanding of the valuation metrics available in every issue of Shares Investment (Singapore).

Price-to-earnings ratio, or PE, is derived by dividing the market capitalization of a company over its trailing twelve months’ net profit.
This oft cited multiple tells us one important thing, namely how fast the investing public expects the company’s earnings to grow. A company with PE of 10 times FY08 earnings would imply that the market expects FY09 earnings to improve 10%.

Due to a statistical phenomenon known as the reversion to the mean, returns from stocks with high PE may lag the market for periods of time, and vice versa. Historically, a PE between 15 and 25 times is considered “reasonable”. For this reason, stocks with high PE of 50 to 60 times often seem to get “stuck”, as their earnings try to catch up with underlying valuation. Or worse, price comes down.

The Price-to-book ratio, or PB, is a recently provided multiple. It is derived by dividing the market capitalization of a company over the difference between its latest total assets and total liabilities.

The market believes a company’s asset value is overstated, or is earning a very poor return on its assets when PB is less than one. If the latter is true, there is a chance that new management or business conditions will prompt a turnaround in prospects and give strong positive returns.

Even if this does not happen, a company trading at less than book value can be broken up for its asset value, earning shareholders a profit.

Dividend yield is simply the full year per share dividend over the current price. It is usually the case for mature companies (apart from REITs) past their growth phase to consistently give dividends.

Absent suitable acquisition targets, the distribution of earnings in the form of dividends improves performance indicators such as Return-On-Equity, and also sends the signal from the management that the “money is there”. Readers however should not hold the misconception that dividends are guaranteed.

Putting The Pieces

Back in August while at a factory visit, a private full time investor told this writer to check up on Action Asia. Its stock has since appreciated by about 50%, but more importantly for learning purpose, is Action Asia still a good buy?

The first step after hearing a “tip” is to know what the company does and how has its financial performance been. In this case, I discovered that this company produces the video entertainment system you see on some cars and tour coaches. In terms of results, it was loss making in FY05 and FY06, but turned around in FY07 on improved contribution from its Hong Kong operations. The company has also recently applied to list Taiwan Depository Receipts.

What do Action Asia’s valuation metrics tells us? Action Asia is currently trading at 5.5 times FY08 earnings. With 9M09 earnings already at $13m, FY09 earnings look very likely to surpass the 5.5% growth as implied by its PE. It is also trading at the lower bound relative to its past 2 years’ PE range (found just below its extended graph) and to the Manufacturing 2 sector (found on page 40).

Action Asia’s PB of 0.8 times offer investors only a slight “margin of safety” – a term which originated from the late Benjamin Graham. As a rule of thumb, the “father of security analysis” advocated buying stocks with 33% “margin of safety” or PB of about 0.67.

Based on PE, PB ratios and a quick survey of its past 5 years’ operating performance, we can preliminary conclude that Action Asia is still a good buy though not a steal. To sweeten the deal, it yields 8.3% backed by a history of distributing dividends even in unprofitable years. Whether this analysis is correct, we can only tell in 3 months’ time, when Action Asia announces its FY09 results.

Flexible Not Mechanical
If you are systematic and diligent doing your “homework”, you should hold on to a stock for at least three months, when most companies announce a new set of earnings. With a new set of figures and guidance coming from management, you can take the appropriate action when the company is not growing according to your analysis.

Although tedious initially, stock picking using valuation metrics is a breeze once you get the hang of it. You must however avoid relying solely on ratios alone, but pair them with your judgement. Buying stocks just because they have low PE or PB, and avoiding when high is reckless.

Take into account any exceptional items in financial statements which might skew PE, PB or Yield, when projecting a company’s future growth. Recall last year, when even good companies wrote down inventories or made provisions for debt for prudence, which resulted in lower earnings and equity, hence higher PEs and PBs.

Those who want to find out more about income statement and balance sheet analysis can visit our web site to read the archived “Education” articles on financial ratios. There is also a convenient feature that displays the company’s PE and PB ratios relative to the relevant sector and index.

Join The Conversation
The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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