How To Valuate If A Company Share Price Is Overvalue Or Undervalue (Part 2)

So How Do We Determine The Growth Rate?

Growth rate can be calculated by using the difference of current year EPS and previous year EPS.

For example,
Company ABC’s Previous Year EPS – $1.50
Company ABC’s Current Year EPS – $1.73

The growth rate → ($1.73 – $1.50) / $1.50 * 100 = 15.33 %
A better way to look at growth rate would be averaging the past 5 years growth rate known as EPS – 5 Years Growth Rate. The reason behind this is that some years the company might be doing exceptionally well, some years exceptionally bad. In that sense, getting a average would be more accurate.

For example,
Year 1 growth rate → 15.33 %
Year 2 growth rate → 25 %
Year 3 growth rate → 10.5 %
Year 4 growth rate → 29.4 %
Year 5 growth rate → 18.6 %
EPS – 5 Years Growth Rate → (15.33 + 25 + 10.5 + 29.4 + 18.6) / 5= 19.77%

PEG Ratio

Once the growth rate is determined, we can divide P/E ratio to the growth rate, and determine if the company is overvalue or undervalue.

For example,
Current Company ABC’s P/E ratio = 33.33
PEG Ratio → 33.33 / 19.77 = 1.6 (Overvalue)

The Bigger The Company, The Lower The Growth Rate

It makes sense that the bigger the company, the lower the growth rate it will achieve. Very often large company find themselves difficult to grow as they are just too big to be managed, in terms of growing the revenue and reducing the cost.

How We Know The Size Of A Company?

Size of company is measured by market capitalization. This can be calculated by multiplying the number of outstanding share and its current share price.

For example,

Current Share Price of Company ABC = $20
Number of outstanding shares = 7,000,000,000 (700 Millions)
Market Capitalization → $20 * 7,000,000,000 = $140,000,000,000 ($14 Billions)

That is to say, if someone wants to buy over the company, it will cost him/her $14 Billion!

The Disadvantages Of PEG Ratio

Although PEG ratio is a more accurate way to valuate a company’s share price. It has its pit fall. Why?

Because the earnings of the company can potentially be manipulated. Some years the company could have exceptionally high earning due to reason, such as disposing off assets (Selling off existing properties). On the income statement it will be reported as profit. However this profit does not come from regular business activity as the company is not able to replicate the event every year.

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