1: The price
Firstly, what is the price of the investment?
It is probably what most investors think: the price the stock is currently trading at. Or the price which an investor has paid to acquire a stock. Let us say Singapore Telecommunications (Singtel) is trading at $5.00, then its price is $5.00. But to an investor who bought Singtel five years ago at $2.50, the price is both $2.50 and $5.00. The latter can be divided into what the investor currently has, which is the average price of their holdings, and what the investor wishes to hold or buy, which is the current price.
Both are important because, when conducting investment analysis, it must be subjective to the investor’s risk, specifically, the degree of risk. The lower the price, the lower the risk. In the example given, an investor who bought Singtel at an average price of $2.50 has lower risk than one who bought it at $5.00. In other words, the price is a gauge for the investment risk, subject to the investor. Higher average prices mean higher investment risk.
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Another way to describe the price of the investment is to consider its volatility. If Singtel has traded between $2.00 to $5.00 over the past five years, would that be considered volatile?
The answer is that it must be compared to something else, or a benchmark. In this case, a good benchmark would be the Straits Times Index (STI), and the stock’s beta would be a suitable measure of its volatility relative to the overall market. A stock beta of 1 denotes that the stock’s price moves in line with the benchmark, while a stock beta of more than 1 indicates that it is more volatile than the benchmark. Since Singtel’s five-year monthly stock beta is less than 1, it is less volatile than the Straits Times Index or the overall market.
So, a higher beta indicates higher investment risk, as it involves more volatile price movements relative to the average movement of other stocks.
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Therefore, for the investor, higher volatility and higher stock prices imply higher risk, relative to a stock with a lower beta and a lower average price. However, investors should be cognisant that higher volatility and stock prices may also suit certain investors, depending on their investment and risk profile. Lower risk does not necessarily mean it is the better choice, because the price should also be compared against other factors, such as the stock’s value.
2: The value
What is the value of an investment?
There is no single clear answer to this, but there are many methods investors can use to determine a stock’s value. More importantly, the stock’s value must be quantifiable and comparable to its price. Without a quantifiable value, it would be tough to figure out whether a stock is worth purchasing. Ideally, the value should be quoted per share, as stock prices are. For example, let us say the price of Singtel is $5.00 and its value is also $5.00.
The methods used to determine the value will be explained in detail in future articles in this series, but a basic description will be provided here.
Firstly, the value can be either a single standalone figure or a combination of multiple series of figures and ratios.
An example illustrates a basic way to look at it. Assume the value of company A, which currently trades at $5.00, is determined solely by its net profit. Company A’s net profit is $1 million. Hence, is the value of company A $1 million?
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On a per-share basis, company A’s net profit is $1.00. So its value is $1.00, since it is comparable to its $5.00 share price. But this is just the first level of determining the value. Investors can also use financial indicators and ratios, such as revenue, cash flow, and margins, to determine a company’s value, but these should be quantifiable.
Just like how price volatility is measured over a period, value can and should be measured the same way. If company A’s price is $5.00 today, it could be $5.50 tomorrow and possibly $10.00 in three months. However, its earnings per share or value only change when company A reports its financial results, usually quarterly or semi-annually.
The value of a company can also be highly volatile, as some companies may alternate between losses and windfall profits due to seasonality or the nature of their business. Regardless, investors should have a sound method for determining a company’s per-share value. Some methods, such as discounted cash flow (DCF) analysis and margin of safety analysis, are effective for estimating this.
As investing involves a certain level of market prediction, it is quite impossible to determine the exact value of a stock at any given time. Since this is the case, the investor should determine a range of values that incorporates elements of the best- and worst-case scenarios. Investors can either take the midpoint of this valuation or forecast the probability of each scenario occurring and arrive at a final valuation for the stock.
So, for company A, let’s say the value is determined by a mix of revenue, net income, operating cash flow, and free cash flow, with weights of 10%, 20%, 30% and 40%, respectively. After computation, company A’s best-case scenario valuation is $8.00, and its worst-case scenario valuation is $3.00. The probability of the former is 30% and of the latter 70%, given a weak market outlook. Hence, the final “value” of the stock is $4.50.
3: The relationship
The relationship between price and value is rather straightforward.
If the price of the stock exceeds its value, then it is overvalued. Conversely, if the stock price is below its value, it is undervalued. In the case of company A, given that it trades at $5.00 and is worth $4.50, the company is overvalued.
However, if a company is always valued based on what it is trading at right now, using the most recent available financial data, chances are that investors can be wrong, persistently. One way to reduce uncertainty is to value the company historically and see how the share price has moved relative to the investor’s valuation.
An example of this would be to look at how a company’s net profits have changed over, say, one year, three years, five years and 10 years. The more periods, the better. If the value of the company is determined by net profits, investors can compare how the share price has moved over the one-year, three-year, five-year, and 10-year periods. If the share price has grown 1%, 2%, 3% and 4% respectively while the “value” has fallen 1%, 2%, 3% and 4% respectively over these periods, then it is a stronger indication that the company is overvalued, as opposed to comparing the price to value growth over one period.
Investors must be careful not to misjudge a stock’s value. They should focus on companies’ earnings and cash flow, as these translate into dividends to reward shareholders or capital to grow the business, which in turn results in higher earnings and cash flow.
Higher earnings per share may translate into higher cash flow per share, which, in turn, benefits the company’s shareholders, as this cash flow can be paid as dividends or reinvested to generate larger profits and cash flow. So, a rule of thumb is that the “value” should generally revolve around these indicators, because the market is never right when it comes to pricing stocks.
Since that is the case, the disparity between the stock’s price and value should present investors with opportunities. The larger the disparity, the more undervalued or overvalued a stock may be. This should also give investors greater confidence to buy or sell that stock. However, investors should be watchful of the different types of price-value growth disparities across multiple periods.
If a stock’s share price is falling but its value is rising, it is a clear sign of undervaluation. If the stock’s share price is rising but its value is falling, then it is clearly overvalued. Investors should also investigate why this is the case, as there may be other factors persistently affecting the share price, including non-financial ones.
If both the share price and the stock’s value are rising or falling, the higher growth rate should determine what an investor should do. If the share price growth exceeds the value growth, it is overvalued. If the fall in share price exceeds the fall in value, the shares are undervalued.
However, it may be very risky to invest in the latter, because the premise of investing in a company whose value is falling is usually not a good idea, unless the investor can determine that the decline is not persistent and will not lead to the company’s liquidation. These companies are usually turnarounds and are only suitable for investors with certain risk profiles.
Conclusion
If there were a formula to determine a company’s value accurately, there would be no need to invest, because every company would be accurately valued and would always move within expectations. Investors should be confident in utilising the disparity between a company’s price and value at any given time to succeed in the stock market.
The next part of the series will present examples of these concepts, along with investment strategies suitable for different scenarios related to the disparity between a company’s price and its value growth.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy or sell stocks, including the stocks mentioned. Any personal investments should be made at the investor’s own discretion and/or after consulting licensed investment professionals, at their own risk. The author of this article does not hold or own any stock(s) featured in this article or have a vested interest in it at the time of writing.
