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Stock valuations in Canada, a peripheral studyArguably, the single most important skill investors can learn is how to value a stock. Without this proficiency, investors
Stock valuations in Canada, a peripheral studyArguably, the single most important skill investors can learn is how to value a stock. Without this proficiency, investors cannot independently discern whether a companys stock price is low or high relative to the companys performance and growth projections.What is a stock?A single share of a company represents a small ownership stake in the business. As a stockholder, your percentage of ownership of the company is determined by dividing the number of shares you own by the total number of shares outstanding and then multiplying that amount by Owning stock in a company generally confers to the stock owner both corporate voting rights and income from any dividends paid.The cornerstone stock valuation metric is the PE ratioThe most common way to value a stock is to compute the companys pricetoearnings PE ratio. The PE ratio equals the companys stock price divided by its most recently reported earnings per share EPS A low PE ratio implies that an investor buying the stock is receiving an attractive amount of value.As an example, lets calculate the PE ratio for Royal Bank of Canada TSX:RY For its fiscal year, which ended on Jan. the company reported diluted earnings was $ At the time of this writing, the companys share price is $To obtain RBCs PE ratio, simply divide the companys stock price by its EPS. Dividing $ by $ produces a PE ratio of for the big bank.Why assign values to stocks?A stocks intrinsic value, rooted in its business fundamentals, is not always the same as its current market price although some believe otherwise. Investors assign values to stocks because it helps them decide if they want to buy them, but there is not just one way to value a stock.On one end of the spectrum, active investors those who believe they can develop and execute investing strategies that outperform the broader market value stocks based on the belief that a stocks intrinsic value is wholly separate from its market price. Active investors calculate a series of metrics to estimate a stocks intrinsic value and then compare that value to the stocks current market price.Passive investors subscribe to the efficient market hypothesis, which posits that a stocks market price is always equal to its intrinsic value. Passive investors believe that all known information is already priced into a stock and, therefore, its price accurately reflects its value. Most adherents to the efficient market hypothesis suggest simply investing in an index fund or exchangetraded fund ETF rather than taking on the seemingly impossible task of outsmarting the market.Using GAAP earnings vs adjusted earnings to determine the PE ratioGAAP is shorthand for Generally Accepted Accounting Principles, and a companys GAAP earnings are those reported in compliance with them. A companys GAAP earnings are the amount of profit it generates on an unadjusted basis, meaning without regard for oneoff or unusual events such as business unit purchases or tax incentives received. Most financial websites report PE ratios that use GAAPcompliant earnings numbers.Nonrepeating events can cause significant increases or decreases in the amount of profits generated, which is why some investors prefer to calculate a companys PE ratio using a pershare earnings number adjusted for the financial effects of onetime events. Adjusted earnings numbers tend to produce more accurate PE ratios.Continuing with the above example, RBCs PE ratio of was calculated using unadjusted GAAP earnings of $ The bank, in its fourthquarter earnings report, indicates its adjusted EPS for the same period is $Using this adjusted EPS value, we can calculate RBCs PE ratio as the result of dividing $ into $ Whats a good PE ratio for a stock?A PE ratio that is good for one investor may not be enticing to another. PE ratios can be viewed differently by different investors depending on their investment objectives, which may be more strongly oriented toward value or growth.Value investors straightforwardly prefer low PE ratios. A stock for which the valuation implied by the market is substantially below its intrinsic value is likely attractive to value investors. Growth investors are more likely to buy a stock with a high PE ratio based on the belief that the superior rate of earnings growth, if not the absolute value of the earnings themselves, justifies the high PE ratio.How investors can use variations of the PE ratioInvestors, particularly growthoriented ones, often use a companys current and past PE ratios to calculate two other metrics: the forwardlooking PE ratio and the pricetoearnings to growth PEG ratio.The forward PE ratio is simple to compute. Using the PE ratio formula stock price divided by earnings per share the forward PE ratio substitutes EPS from the trailing months with the EPS projected for the company over the next fiscal year. Projected EPS numbers are provided by financial analysts and sometimes by the companies themselves.The PEG ratio accounts for the rate at which a companys earnings are growing. It is calculated by dividing the companys PE ratio by its expected rate of earnings growth. While most investors use a companys projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections for shorter periods of time increases the reliability of the resulting PEG ratio.Continuing with our RBC example, analysts forecast average annual EPS growth over the next three years of per year. Dividing Walmarts PE ratio of into produces a PEG ratio of A stock with a PEG ratio below is considered as exceptionally valuable due to its impressive projected growth rate.Other valuation metricsSeveral metrics can be used to estimate the value of a stock or a company, with some metrics more appropriate than others for certain types of companies.Pricesales ratioAlong with the PE ratio, another common metric used to value stocks is the pricesales PS ratio. The PS ratio is equal to a companys market capitalization the total value of all outstanding shares divided by its annual revenue. Because the PS ratio is based on revenue instead of earnings, this metric is widely used to evaluate public companies that do not have earnings because they are not yet profitable. Stalwart companies with consistent earnings such as RBC are rarely evaluated using the PS ratio. Investors who wish to compare the PS ratios of different companies should be careful to only compare PS ratios of companies with similar business models. Across industries, PS ratios can vary greatly because sales volumes can vary greatly. Companies in industries with low profit margins typically need to generate high volumes of sales.Pricebook ratioAnother useful metric for valuing a stock or company is the pricetobook ratio. Price is the companys stock price and book refers to the companys book value per share. A companys book value is equal to its assets minus its liabilities asset and liability numbers are found on companies balance sheets A companys book value per share is simply equal to the companys book value divided by the number of outstanding shares.A companys pricetobook ratio is only marginally useful for evaluating companies, like software tech companies, that have assetlight business models. This metric is more relevant for evaluating assetheavy businesses, such as banks and other financial institutions.Its a value trap!A stock can appear cheap but, because of deteriorating business conditions, actually is not. These types of stocks are known as value traps. A value trap may take the form of the stock of a pharmaceutical company with a valuable patent that soon expires, a cyclical stock at the peak of the cycle, or the stock of a tech company whose onceinnovative offering is being commoditized.Other relevant factors for valuing a stockAside from metrics like the PE ratio that are quantitatively computed, investors should consider companies qualitative strengths and weaknesses when gauging a stocks value. A company with a defensible economic moat is better able to compete with new market participants, while companies with large user bases benefit from network effects. A company with a relative cost advantage is likely to be more profitable, and companies in industries with high switching costs can more easily retain customers. Highquality companies often have intangible assets eg patents, regulations, and brand recognition with considerable value.As Warren Buffett famously said, Its far better to buy a wonderful company at a fair price than a fair company at a wonderful price.Please summarize it by explaining five main points in this report about stock valuation. Give some examples in numeric forms.
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