Key ratios for value investors

on Oct 18, 2012 in Equity, Home | 1,324 comments

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Value investing implies chasing shares worth less than they should be and therefore considered undervalued.

Because a share’s price is a combination of investor estimates for growth, revenue and dividends, it is also a matter of opinion as to whether that share is undervalued.

The most common way to apply a value measure to a share is Price/Earnings ratio. Dividing a share’s price by its earnings per share is a standard way to grab a snapshot of a share’s value. A very high P/E implies that the share is considered overvalued, however lower P/E doesn’t always account for growth potential.

By combining the P/E ratio with a share’s expected 12 month growth rate you derive the PEG ratio. It is one of the best ways to screen shares because it summarizes information about a company’s financial performance in an understandable way.

The PEG ratio can offer a suggestion of whether a company’s high P/E ratio reflects an excessively high share price or is a reflection of promising growth prospects for the company.

PEG ratio = (Price/Earnings ratio) / annual EPS growth

PEG is a widely used indicator of a share’s potential value. It is favoured by many over the Price/Earnings ratio because it also accounts for growth potential. Similar to the P/E ratio, a lower PEG means that the share price is undervalued.

An investor would probably be wise to check out the future growth rate by determining how much the most recent quarter’s earnings have grown, as a percentage, over the same quarter one year ago. Dividing this number into the future P/E ratio can provide a more realistic PEG ratio.

Occasionally share price reflects more investors’ sentiment rather than a company’s long term profitability. Over time, inefficiencies are corrected and prices realign with intrinsic values. Value investors seek to buy companies whose shares appear underpriced relative to the underlying fundamentals.