Analysts have many financial measures to value companies. Here's a brief overview.
Share market investment analysts thrive on numbers.
So, when you read reports about markets or specific companies being “overvalued” or “undervalued”, you can generally assume there’s been a fair bit of analytical number crunching going on behind the scenes.
But how do investment analysts reach their conclusions? Is there a magic formula available that you can use to work out if you’re paying over the top, or getting a bargain?
The answer to that question probably lies somewhere between yes and no, depending on a whole range of different factors.
How analysts value companies
A golden rule of investing is to always do your homework before parting with any money.
If you’re looking to invest in individual companies, part of your due diligence may involve reading research reports written by investment analysts.
Typically, among other things, investment analysts will provide a detailed overview of a company’s current operations, past business performance, and its future earnings and growth outlook.
Based on their findings, they’re likely to produce a recommendation such as “buy”, “hold”, or “sell”.
To reach a conclusion on what they consider to be the “fair value” for a company’s shares, investment analysts have a large toolkit of quantitative measures at their disposal.
Here’s some of the common ones:
The P/E ratio
Commonly referred to as P/E, the price-to-earnings ratio is determined by dividing a company’s current share price by its latest earnings per share.
Earnings per share, or EPS, is calculated by dividing a company’s most recent net profit by the number of shares it has on issue to investors.
In essence, the P/E ratio shows what investors are willing to pay now (the current share price) for a company based on its past earnings.
A high P/E could signal that a company’s share price is high relative to its earnings, while a low P/E could mean the opposite.
Sometimes a high P/E reflects that the market is willing to pay more for the company due to the expectation of above average future growth. To take this into account, some analysts look at forward looking metrics such as the PEG ratio.
The PEG ratio
The PEG, or price/earnings to growth ratio, takes the P/E ratio to a new level.
Instead of just focusing on EPS (which is the past performance measure used for the P/E ratio), the PEG adds the expected future earnings growth rate into the measurement equation.
It’s calculated by dividing the company’s P/E ratio by its future growth rate.
A lower PEG suggests a company is undervalued relative to its future growth compared to a higher PEG.
Return on equity
Return on equity, or ROE, is calculated by dividing a company’s net income by its net assets (total assets minus total liabilities).
ROE is one way of determining how well a company may be performing. A higher ROE suggests a company is better at using shareholder equity to generate profits.
Free cash flow
Free cash flow is essentially the cash left over after a company has paid its operating and capital expenses.
If a company has a high free cash flow, it shows that the company is generating excess cash. This can either be deployed back into the business for further expansion of used to pay shareholder dividends.
Investment analysts often factor in free cash flow as part of their future growth analysis.
The benefits of diversification
Investment analysts have many financial measures at their fingertips, but it’s quite common for a group of analysts to use exactly the same measures and reach different conclusions.
Why? Because, beyond quantitative measures, there’s also a large degree of subjective judgement when it comes to deciding on a company’s investment recommendation.
That’s why you often see companies have a range of share price forecasts from different investment analysts.
You do have an alternative route though, which avoids having to do your own number crunching or having to decipher specific analyst recommendations.
That route is all about diversification.
Instead of focusing on just a few listed companies recommended by analysts, why not cast your investment net over hundreds, or even thousands, of companies using a managed fund or exchange traded fund (ETF)?
A broad-based index fund will typically invest in many companies, usually proportionately based on their market capitalisation, with its largest holdings being in the biggest listed companies.
As an investor, that means you’re essentially buying into all the companies that tick the boxes that investment analysts are looking for.
It’s the same strategy that Vanguard’s founder, John C. Bogle, pioneered more than 45 years ago when he launched the first index fund.
Rather trying to find one listed company or a few companies that may deliver a great investment return over time, he advocated investing much more broadly across the wider universe of listed companies using index funds.
Having broad diversification across many companies is a proven strategy to reduce share portfolio risk and has consistently delivered strong investment returns over the long term.