I categorized valuation methods in a going concern and liquidation concern. The valuation method that I use for companies that will continue doing business (going concern) is a simple Price to Earnings Ratios (PE ratio) multiples while for companies that will not continue doing business in the future is the book value (BV) of the company.
Price to Earnings Ratios (PER) is computed by dividing price by earnings per share. The PER computed will be used as a multiple to determine the intrinsic value of the company that is in a going concern (will continue doing business).
Valuing Company A that has the following information:
EPS = 0.40
PE ratio multiple (PER) = 10
EPS x PER = Intrinsic Value
0.40 x 10 = P4.00
Based on the above calculation, Company A has an intrinsic value of P4.00. Company A will be undervalued if the company is priced by the market substantially below P4.00.
The multiple to be used in the calculation of the intrinsic value is determined by:
- Relative to other companies in the similar industry – Obtain the average PER of the companies in the industry.
- Desired hurdle rate or return on investment – the inverse of the PER is your desired return on investment. Should you use a PE ratio of 10x, your desired return on your investment is 10% (1/10). Should you use a PE ratio of 20x, then your desired return on your investment is 5% (1/20).
There are many advantages and disadvantages in this valuation and one of it is if the market will not recognize the PER multiple you used in your valuation. I often use a PER multiple of 10x or a PER multiple in the most comparable company of the company I am trying to value. I do not average the PER for the obvious reason that averaging the PER will neglect the fundamentals of the companies that served as a reference of the PER.
Bruce Greenwald, a respected authority in value investing, considers multiplying EPS by PER multiple to determine the intrinsic value as a laughable valuation method. He uses discounted cash flows (DCF) in valuing a company.
DCF is indeed the most logical method in valuing a company. However, forecasting cash flows is hard for most companies and relying on DCF method will put an investor at risk of using faulty free cash flows assumptions (not to mention, time consuming). I only used DCF method in valuing Meralco since free cash flows can be easily estimated with reasonable certainty.
A company that is perceived not to continue doing business (liquidation concern) generally have an intrinsic value equal its book value. A conservative liquidating concern companies are those that has a market value less than the net working capital (current assets less current liabilities). Investments like these are called net-nets.
Buying companies solely for the reason that is below book or at low PER is not a good investment strategy. Buying undervalued companies but with incompetent management and poor business model will leave the investor stuck in a value trap. A value trap is a company trading at “undervalued” levels but has no foreseeable catalyst to unlock the value. A company should be purchased after considering future business developments and its corresponding impact on its earnings and cash flows.