Our goal in the stock market is to aim for the highest returns possible from our investment. “Buy low, sell high” is possibly the most famous advice about making money in the stock market. Yup, just buy when the stock price is at its lowest and then sell when it reaches the top.
“See this company’s price chart? Just buy at this price last year February and then sell them one month ago and you would have the biggest return!” Easy, huh?
Unfortunately, it is really NOT the share price that matters, but the INTRINSIC VALUE.
THE PROBLEM WITH BUY LOW, SELL HIGH
Everyone knows when to buy low, sell high, when it is already in the past. We know when the stock price is at its lowest… when it starts to rally up… and when it suddenly plummets from its highest point. However, when you are in the moment, deciding whether to buy or sell a company based on their share price, we will never know how low is low enough and how high is high enough.
Things get worse when people actually do the opposite in the stock market.
Think about it. People rake in purchases during major sales in shopping malls but turn the other cheek when prices increases.
And yet, when it comes to the stock market, we do the exact opposite. When stock prices fall, we immediately dump in fear because we can’t stand the red numbers showing how much we are losing every day.
But when share prices are increasing, we rake in more because we fear we’d miss out and be worried that someone else is getting richer than us. And most of the time when we buy, the stock price is already at the peak.
Not a mention about things that matter, like dividend yield or the company’s growth.
So, how do we solve this problem? Now here’s the biggest secret most mom and pop investors do not know, and we would like to share this revelation to you. Close the door and listen very, very carefully.
Do you know that the stock price that you saw in the stock market is not really the true value of the company? Most people do not know this, only the famous value investors! They assume that the stock price shown in the board is the company’s value itself. That’s a big serious mistake! Every single company has their own true value which is totally distinct and separated from the price shown in the stock market itself. This is what we call the intrinsic value of the company.
Therefore, to solve the problem of buy low, sell high, we need to have a comparison in order to know what price is low or high enough. The intrinsic value of the company is the benchmark comparison that we will use as an anchor to decide when to buy or sell a company’s stock. For example, Company ABC’s stock price is now $100. How do we know this price is low or high? We will only know when we have Company ABC’s intrinsic value to compare. Let’s say we calculated it and Company ABC has an intrinsic value of $70.
Ah, now we know that $100 is actually very high and it’s currently overvalued. It’s very important to note that we only buy a company’s stock when it’s undervalued but still has solid fundamentals. Let’s say crisis hits and its stock price plummets to $50. At this price, we will have the confidence to buy because we know for sure it’s currently undervalued and cheaper than $70. That’s how we buy low, sell high. A lot better than investing blindly, isn’t it?
Alright, alright. We know you are now anxious to know how to calculate the intrinsic value of a company. We promise that if you can master this skillset, you will be a much better investor than 90% of the people out there. Here, we have 3 basic ways on how to find out a company’s intrinsic value. Let’s start.
PRICE/EARNINGS TO GROWTH RATIO OR PEG RATIO
The first valuation is what we call the “PEG Ratio” or Price/Earnings to Growth Ratio for growth investing. We will only use this valuation based on fast growing companies. The formula for PEG ratio is derived by dividing the stock’s price-to-earnings (P/E) ratio by the earnings growth rate for a specified time period.
So what is a good PEG ratio? Well… PEG must be equal to 1 for it to be fairly valued or less than 1 to be undervalued.
This formula was developed by Peter Lynch, the legendary former manager of the Magellan Fund at Fidelity as a way to solve the problem of P/E ratio when different companies has different growth rates. If two companies are trading at PE 10x and one of them is growing at 5% but the other is at 15%, we will know that the latter as a better bargain due to its higher growth and thus giving us a higher return.
The PEG ratio formula calculation is simply done by using the following steps:
- Find out the current share price of the company.
- Determine the latest net profit of the company.
- Divide the net profit with the outstanding shares in order to get the earnings per share (EPS) of the company.
- Next, divide the current share price of the company by its earnings per share (EPS) to get the P/E ratio.
- Then, determine the EPS growth rate of the company based on the past 5 years performance of the company. For example, if the 1st year has EPS of $10 and 5th year has EPS of $20, the company has an EPS growth rate of 14.87%.
- Finally, the formula for PEG ratio calculation is derived by dividing the P/E ratio by the growth rate of its earnings for a specified time period.
For example, Company ABC’s stock price is $100. It has an EPS of 10 which means it has a P/E ratio of 10. Company ABC has a growth rate of 20% for the past 5 years. Therefore, its PEG ratio is PE 10 / 20% growth rate = 0.5. Since PEG = 1 is fairly valued, we can say that Company ABC’s intrinsic value is $200 but its stock price is only $100. So, we conclude that this company with a stock price of $100 is undervalued with a huge 50% discount.
By the way, if you’re looking for a shortcut (we’re talking SECONDS kind of short), you can use WealthPark screener to automatically filter for companies with this criterion,
and pretty much forget about all the calculation processes above.
Your time is too precious!
Btw, this also works with the next 2 criteria I’m about to share
PRICE-TO-BOOK RATIO OR P/B RATIO
The second valuation is what we call the price to book ratio, or P/B ratio for asset play companies. We calculate this by dividing a company’s stock price to its book value per share. Book value is what we normally term at the net worth of the company which is total assets minus total liabilities. We normally use this valuation on companies with huge tangible assets like cash, lands and properties. P/B ratio must be equal to 1 for it to be fairly valued or less than 1 to be undervalued.
Book value is more easily related to everyone because we use this valuation method everyday when it comes to property investment for capital gain. When it comes to buying properties, we do not simply pay the price the seller quotes to us similarly to the share price in the stock market. The next thing we do is to conduct our due diligence by calling a property valuer or bank in order to get the market value of the property. This property market value is the same as the intrinsic value of the company that we have always been talking about. We will only buy the property when the seller’s asking price is equal or below the market value of the property. This analogy is exactly the same when it comes to stocks. We will only buy when the share price of the company is equal or below its book value.
The P/B ratio formula calculation is simply done by using the following steps:
- Find out the current stock price of the company.
- Find out the book value of the company by assets minus liabilities.
- Next, divide the book value by the number of outstanding shares, in order to find the company’s book value on a per share basis.
- Finally, divide the company’s current stock price by the book value per share.
For example, Company ABC has a book value of $10 million on its balance sheet. It has 10 million outstanding shares. This means its intrinsic value is based book value per share of $1. If the current stock price is $0.50, this gives a P/B ratio of 0.5. So, we conclude that this company with a stock price of $0.50 is undervalued with a huge 50% discount.
One easy way to calculate a company’s intrinsic value is by calculating what kind of yield that you expect to receive from the company. Dividend yield is calculating a company’s annual dividend pay out and its current stock price. As a general rule, we would want to receive a dividend yield which is higher than our fixed deposit interest rate or 6% and higher dividend yield in a year as stocks is a riskier asset and we want to be rewarded proportionately to the risk taken.
This valuation method is also the same when we invest in properties if it’s purely for rental cash flow. We calculate rental yield the same way as dividend yield. Let’s say an apartment is $700,000 and we want to get at least 6% rental yield from this. After doing our research, the annual rental we can get from this apartment is about $30,000 which translates to only 4.2% rental yield. So, we must negotiate or wait for the price of the house to fall to $500,000 in order to get our 6% rental yield.
Typically, we only use this dividend yield valuation method for big and mature companies that pays a consistent dividend every year and with strong cash flow from their business. Reason being that these companies has not much room to grow left and it would be better to return the money earned back to the shareholders.
The dividend yield formula calculation is simply done by using the following steps:
- Find out the current share price of the company.
- Find out the dividend payout per share.
- Divide the dividend per share with the company share price.
For example, Company ABC now has a share price of $150 and it pays out an annual dividend of $6 per share consistently every year which only gives 4% dividend yield. As such, in order to get a 6% dividend yield, the intrinsic value of the company would be $100 because it only pays $6 dividend per share annually.
So, there you have it, you have the PEG ratio for growth play companies, P/B ratio for asset play companies and dividend yield for dividend play companies. There are a lot of numbers and calculations involved but once you have done your homework, you will be rewarded well. Understanding a company’s intrinsic value will not only help you buy low, sell high but offers further conviction in your investment journey because it helps you to know whether you are buying a company at cheap or expensive price.
Some of us may lament that it’s too troublesome and difficult to find out a company’s intrinsic value. That’s just 1 company.
Well, you are ABSOLUTELY right.
What if we are researching for 100 companies? What if, at the end of it, we realized we got all the calculations wrong?
Thankfully, with WealthPark, all of that is taken of within seconds… and I mean, SECONDS.
No need to:
- Dig around for all the financial information.
- Calculate complex formulas, with the risk of getting everything wrong at the end.
And you can IMMEDIATELY
- See the company’s intrinsic value, PEG ratio and dividend yield
- Get 10 years’ worth of a company’s track record.
- Tell if the stock is worth it, in minutes.
We’ve done all the work for you; all you need is to choose!
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author(s) involved in the writing of this piece do not have current vested interest of the company. Please consult a competent professional for expert financial, or other assistance or legal advice.