Updated: Aug 17, 2020
We continue our lessons in our series of 'Stock investing for beginners'. This time we will look to find stock value to find the best stocks to invest in. For training purposes, we will evaluate Toyota and Tesla stock value.
Understanding the value of the stock of the company and comparing it with its price is likely the main key to success in the stock market investment. Comparing the value and the price allows finding the undervalued stocks for investment and discard overvalued (unless you trade with "follow the hype" strategy).
How do you understand if a share is under or overvalued? What should you pay attention to when choosing a company shares for your next investment?
Toyota Motors (TM) stock is priced at $133.67 while Tesla is priced at $1,600 per share. Does it mean that Tesla is worth more? In reality, the price of a share is just a number, which in itself does not mean anything.
The number of shares can be very small or extremely large. And the number of shares impacts the price per share. For example, Toyota has 1.4B shares, while Tesla has 186.36M shares outstanding (7.5 times more shares). In fact, a company may decide to split its shares, meaning it will have more shares, but the price for each will drop. This is the route that Tesla is going with 1-to-5 stock split meaning it will have 186.36M times 5 number of shares, but the price per share will drop 5 times (on the day of split at least).
Why do companies decide to split shares?
The answer is quite simple: high prices make it difficult to trade shares. While there are more and more brokers offering to buy fractions of shares, there are still a lot of brokers that only allow buying full shares. When prices per share are too high, it makes it difficult for a novice investor with limited funds to buy them (buying even 1 Tesla share may be problematic).
Some companies or ETFs never split or split very rarely. Warren Buffet only allowed stock split once for Berkshire Hathaway Inc. The split happened in 2010, with an astonishing 50 to one split. However, the stock price is still currently priced at $318,000 and there are just 657.91K shares. Can you afford to buy a couple?
Thus, it is not the stock prices that need to be compared, but the value of the entire business.
1. How to calculate the stock value of the company?
In another way, the value of a company is called market capitalization. Let's say you are deciding between Tesla (prior to the split) and Toyota. To find out how the stock market values a public company, multiply the value of its share by its total shares outstanding. Based on the results of these simple calculations, you will see that Tesla company is valued roughly 60% more than the Toyota company.
The capitalization of a company on the stock exchange is based on the opinion of investors about how much the company should be worth. The stock price is just a factor of the company's worth.
Decisions to buy its shares can be made in different ways: someone likes the brand, someone is trying to assess the quality of the business. For those who choose the latter option, the fastest and surest way to assess quality is to find out how profitable the company's business is.
2. Comparing the stock value and profitability of the company. P/E and E/P multipliers.
A share in a public company is a share in a business. To understand how much it should cost, you need to estimate how soon the investment in a particular company will pay off. The investment in the shares of a company may pay off in a few ways:
The company can return the money to the investor in only one way: share of the profit, that is, pay dividends.
In addition to paying dividends, a company can use its profits to further grow its business. Then the financial performance of the issuer may improve, and its shares will rise in price. In any case, you will either immediately return part of the money, or your share will rise in price.
The company may be acquired by a bigger player. This player will buy the company based on the profit the company will bring for the money it invests. At this moment shareholders get paid for their shares (usually with a premium).
To estimate the value of a share, compare its price with the company's profit:
If you buy all Toyota shares at the current price and its annual profit does not change, then you will need about 13.4 annual profits for your investment to pay off. If you buy Tesla company on the same terms, it will pay off in about 810 years.
Formulas for such a stock valuation are called multipliers. These are derived indicators that reflect the relationship between the financial results of a company (profit, revenue, debt, capital) and its capitalization.
The capitalization/profit (P/E, price/earnings) multiplier shows how many years the investment will pay off if the share price and the company's profit remain at the same level.
If Toyota's profit doubles next year, its P/E will drop to 6.7, and if the share price and earnings remain at the same level, the investment in this company will pay off twice as fast. If Tesla's profit doubles, the investment in this company will still pay off only after 405 years.
The most common way investors calculate P/E is by dividing share price by EPS (Earning-Per-Share). For example, Tesla's share price is $1,600; EPS for the past 4 quarters is $2.03. This gives P/E of 810 - the same number as we saw in the table above (some differences would be due to rounding).
For Toyota, the share price is $134, earnings-per-share in the fiscal year 2020 were $10.1, which again gives a P/E of 13.4.
There is another useful multiplier is profit/capitalization (earnings/price). It shows how much interest you can potentially earn in a year from dividends and changes in the value of a share if the share price and the company's profit remain at the same level.
To calculate E / P, divide your annualized return by capitalization and multiply the result by 100 to get the percentage:
Whichever method of calculation you choose, remember that this is just a theoretical forecast. In this model, it is assumed that the share price depends only on profit and does not take into account the influence of external economic factors, news background, and public opinion.
By themselves, P / E and E / P multiples only show whether a company is cheap or expensive at its current profit and share price levels. They don't say anything about whether the business is effective.
3. Comparing the stock value of companies taking into consideration projected earnings growth. Price-to-Earnings-Growth (PEG) and Forward PE multipliers.
So, why there is such a big difference in how investors value companies. One company has a P/E score of 13, another - above 800. Part of it is obviously due to the hype around some companies and their managers. These hypes (bubbles) occur here and there very often.
Another reason for the difference in P/E is the growth potential of the company and the expected growth of the company's EPS in the future.
There are a lot of companies and even categories that either grew so much that exhausted room for growth. Other companies are being squashed by competitors and stopped growing. Despite they may have good profit levels investors also want to see earnings growth. This is why they rather chose a company with a higher P/E, but that is likely to grow. Other reasons for lower P/E may be problems with debt, the company's management, lagging on innovation, etc.
For example, Toyota is expected to grow its earnings by an average of 3.40% in the next 5 years (based on analyst predictions). Tesla is expected to grow earnings at an average of 76% in the next 5 years.
For example, if we fast forward 5 years and check the estimated earnings at the end of 2024 we will see that Toyota is expected to have EPS of $16.06, Tesla - $28.85. So, you can see why Tesla company is valued currently more than Toyota.
We can use these future EPS scores to calculate forward P/E - one of the metrics that I use in evaluating companies. If we take 2024 expected earnings and current prices the forward P/E will be:
As you can see Tesla is quickly reducing its PE score; however, it is still a bit high. The question is: will it be able to grow at the same level for the 5 years after 2024. It seems many investors (outside of those who are just riding the hype) think that yes. Only then it makes sense to buy at the current price and then wait for at least 5 years - are you that kind of a long-term investor?
Another metric that takes into consideration the current profit and its future growth is Price-to-Earnings-Growth (PEG) ratio. Under this metric, you need to divide current P/E by average expected earnings growth in the next 5 years. PEG of 1 to 1.5 is considered to be in "OK" range. PEG above 1.5 means the company is overpriced. PEG under 1 may mean the company is underpriced.
For example, for Toyota PEG = 13.4 / 3.5 = 3.8
For Tesla PEG = 810 / 76 = 10.7
Both companies are overpriced at current prices and growth expectations.
A word of caution on PEG under 1 score. Sometimes this happens when there is risk associated with the category. For example, the whole airlines category trades at PEG under 1 (even outside of COVID times). This is because investors know that the airline category goes through the cycle when every 6-10 years the category goes through another price war and many companies in the category go out of business, only the biggest companies survive.
4. Invest in business, not formulas
Businesses can be different. For example, oil and gas are conservative industries that have already passed the stage of rapid development and are now relatively stable. IT and media business - on the contrary, are innovative market sectors where an unknown company can become a leader in a few years.
The low P/E may show that the value of the company's shares is unlikely to fall lower - it is more likely to rise. However, this does not mean that investing in this company is a good investment idea. It only means that it is cheap. On the other hand, if Netflix doubles its profits annually over the next 10 years, as it has done so far, it doesn't matter that it has a high P/E. Investments in this company will pay off much faster. The same is true for Tesla.
Here are some tips on how to measure the quality of a business:
Understand the business you are investing in. Find out how the company makes money, what it owns, what is its debt load.
Watch the dynamics. The profit that a company makes from its core business is called operating profit. Let's say the company sells a large part of the business and receives a one-time income, thanks to which his annual profit doubles. It will not be possible to sell the asset for the second time, which means that next year the profit will be lower. To correctly estimate revenues, look at the dynamics of the company's profits over the past few years. The data can be found in free financial services such as Google Finance, Yahoo Finance, Investing.com, MarketWatch.
Make your own decisions. Stocks can be undervalued or overvalued for a long time. In general, the market can be wrong for a long time, but when you build a portfolio of securities, you still need to find a foundation for making decisions and pick stocks. The P/E, forward P/E, and PEG scores are a good baseline.
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