DAY9 Education : Finding The Value Of A Company

Hey, tigers!

US Stock Financial Statements for Beginners

Today is our 9th day of "Learn US financial statements".

In this article, I mainly introduce: finding the value of a company.

In our previous articles, we've learned how to use financial statements to select the highest quality leading stocks.

But many of us still run into problems in practice.Suppose you're very optimistic about a stock. You've done detailed research on the financial statements and the company's business model.

The financial data is good and there's no reputational risk in the short term, but the stock price just keeps falling.Or take another example. A company's financial statements and the stock fundamentals are impeccable.

The stock price is high, however, and you're afraid to buy it. And although the stock just keeps going up, you're afraid to bet on that remaining the case, so a chance is lost.

So, how to judge whether a company's share price is expensive or not?

In this article, I'll use three indicators to tell you the answer!

The first indicator: PE

To determine whether a company is a good price, we usually use valuation indicators.

The first is the Price Earnings Ratio, or PE;

The P/E formula: P/E = stock price / earnings per share
= stock price * company total cap / earnings per share * company total cap
= company total market capitalization / company net profit

So what does the P/E ratio actually mean? I'll share an example with you.Jack had opened a restaurant beside a school.

Recently, it is due to cash flow problems he decided to sell it up. The restaurant was in a good location and business was going well. Annual net profits were approaching $200,000.Jack thought about this.

With these net profits and in this kind of location, if he only asked for $200,000 for the place, he'd be losing out. So he asked for $1,000,000 for the transfer of the business.

The next day, Rose saw the transfer notice and made an appointment with Jack to talk further. Having reviewed all the inventory streams, Rose decided to take the plunge.

So, for Rose, P/E = 1,000,000 (estimated total market capitalization)/200,000 (annual net income). This works out to a P/E of 5x, which means, assuming the restaurant’s market value and net profits remain constant,

it will take Rose five years to break even.P/E tells us how many years it will take to recoup invested capital. The quicker that happens, the better – so, usually, a low P/E ratio can be seen as a good sign.

The second indicator: PB

Now let's talk about the second indicator: Price-to-Book Ratio or PB.The P/B formula: PB = share price/ net assets per share
= share price * company total cap / net assets per share * company total cap
= company total market capitalization / company net assets

Let's look at another example to help us understand this concept.Rose runs a restaurant next to the school and it's been doing very well. Rose decided to sell the restaurant, which was profitable, because her family was in dire need of money.Because she's in urgent need of funds, she decides to sell it at cost.

This means a price tag of $1,000,000 for the entire restaurant. Jack gets in touch with Rose as soon as he sees the notice of sale. When he values the various tables, chairs, and kitchen equipment in the restaurant, he finds that they alone amount to $1,000,000.

Even if the restaurant doesn't do any more business, he won't lose money by selling them! Jack thinks this is a pretty good deal, so he pays the price tag and takes on the contract.So for Jack at this point, P/B = 1,000,000 (total market capitalization)/1,000,000 (net assets).

This works out to a P/B of 1, which is equivalent to Jack buying the store at cost.This example shows us that P/B is about how much it costs you to buy an asset.Of course, when you buy an asset, the lower the cost, the better. So, generally speaking, a low P/B ratio means the company is relatively undervalued.

The third indicator: PS

Finally, let's look at our third indicator: Price-to-Sales, or PS. 

The P/S formula: P/S = share price / sales per share
 = total market capitalization / total revenue

We can see from the formula that the greater the total revenue, the lower the P/S ratio will be.

So, generally speaking, the lower the P/S ratio, the greater the investment value of the company's stock.

Among the various tools for valuation analysis, the P/S ratio is one of the most frequently used metrics.For mature enterprises, P/E and P/B are normally used for valuation.

On the other hand, P/S is more reliable for high-growth enterprises that haven't yet seen profits.

The P/S ratio will not be negative. For loss-making or insolvent enterprises, there is a meaningful value multiplier.

At the same time, the P/S ratio is relatively stable, reliable, and resistant to manipulation.

That's it for today's article. Let's make a brief summary:

We know that three measures can be used to value a company: price to earnings ratio (P/E), price to book ratio (P/B), and price to sales ratio (P/S).

One more thing, these valuation methods are the most common and basic methods on the market.

There are many others – I hope over time, you can become familiar with them all.

Now that you've mastered the concept of valuation, you'll never need to use "stock price" to measure value again！