How To Valuate If A Company Share Price Is Overvalue Or Undervalue (Part 1)

Price to Earnings (P/E) Ratio

This is the most commonly method used to valuate if the company share price is overvalue or undervalue.

The formula → Current Share Price divided by Annual Earnings Per Share (EPS)

For example,

Current Share price of Company ABC = $20
Earnings Per Share over the last 4 quarters = $1.50
P/E Ratio –> $20/1.50 = 13.33

In another words, for every $1.50 that was invested, it will take about 13 years for the company to earn back the $20.

The higher the P/E ratio, the longer period it will take the company to earn back the investor’s money which was previously spend for growth and expansion.

So, It may look like the higher the P/E Ratio, the more overvalue of the company, since it is taking longer to earn back the invested capital. But, that’s not necessary the case.

If a good company is expected to grow its earning at the rate of 30 percent every year. Then it means that the company is able to earn back the money at a faster rate! The P/E ratio itself does not tell the full picture of the growth rate!

For example,
Current Share price of Company XYZ = $50
Earnings Per Share over the last 4 quarters = $1.50
P/E Ratio –> $50/1.50 = 33.33 (Looks overvalue)

Let’s assume the growth rate is 30% every year and the stock price did not change after 5 years.

EPS after year 1 → $1.50 + ($1.50 * 30/100) = $1.95
EPS after year 2 → $1.95 + ($1.95 * 30/100) = $2.54
EPS after year 3 → $2.54 + ($2.54 * 30/100) = $3.30
EPS after year 4 → $3.30 + ($3.30 * 30/100) = $4.29
EPS after year 5 → $4.29 + ($4.29 * 30/100) = $5.58

Now let’s look at the new P/E Ratio → $50 / $5.58 = 8.96 (undervalue)

So as you see can see, by simply looking at P/E ratio, it does not tell you the full picture. It all depends on the growth rate of the company. Remember, companies went public for the sole purpose of growing bigger and bigger.

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