Stock Valuation Basics: How to Tell If a Company's Shares Are Well Priced

It would be hard to find a podcast-hosting duo more fully invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they even put "Answers" in their show's name! This week they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they have recruited senior analyst -- and frequent podcast guest -- Ron Gross to help out.

In this segment they tackle one of the fundamental questions every investor has to consider: How can one tell what the real value of a company is, relative to its market cap and share price?

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on June 25, 2019.

Alison Southwick: The next question comes from Dave. "Have been listening to Answers and Rule Breaker Investing for a couple of years and that experience drew me into joining both Stock Advisor and Rule Your Retirement."

Ron Gross: Nice!

Robert Brokamp: Heeey!

Southwick: "One of the things that concerns me is that I still feel like I'm somewhat blind in my investing approach. I would like to learn more about how to determine the value of a company. Ideally you guys or Rule Breakers could do a regular episode on how to do that. If I cannot entice you, some recommendations for a non-finance person on how to get started would be appreciated." Ron?

Gross: Oh, Dave!

Southwick: Question!

Gross: Oh, Dave! I could teach a semester-long class on valuation. Maybe two semesters of long classes. I'll give you 10 seconds of free advice. I'll do my best!

I think the simplest thing for an individual investor to do is focus on what we call "relative valuation measures" and those are basically in the form of ratios. Price-to-earnings ratio is probably the one that people are most familiar with -- P/E ratios. Other valuable ones would be the enterprise-value-to-EBITDA ratio or the price-to-operating-cash-flow ratio...

Southwick: More on EBITDA later.

Gross: Later, yes. I teased the question.

Southwick: A teaser for you.

Brokamp: I was going to turn it off, but now I'm staying!

Southwick: She's come for the ratios. You stay for the EBITDA. Here's what you can do. You can calculate these ratios; but, as I mentioned, they are relative valuation metrics, which means you need to compare them to something. They're not useful in a vacuum just by themselves.

What do you compare them to? Let's take a P/E ratio. Let's say you calculate a P/E ratio of a company and it turns out to be 18. That means the price is 18X the earnings. Price divided by earnings. What does "18X" mean in a vacuum? Nothing. But if you compare it to its peers or its competitors and you see that those are trading at 25X earnings while your company is only 18, that's something interesting to note. It may be an indication that your company is cheaper; cheaper being an interesting word, but perhaps "undervalued relative to the peers."

You can also compare that 18 number to how that company traditionally has traded in the past. Again, if that company traditionally trades at 14X earnings and now it's 18; well, based on historic data, that company could potentially be expensive right now.

And the third thing you could compare it to is the market as a whole. The S&P 500 has its own P/E ratio. So you can look at how your company is trading, relative to the market as a whole, and compare that to historical data, as well. Three different ways that you can get a gauge on a relative valuation metric.

An absolute valuation metric would be something like running a discounted cash flow and that's a whole semester in and of itself. We won't go down that road. I don't think it's really necessary for an individual investor. But using some key metrics, some key ratios would be a really nice thing to add into the research you do with most of the research being focused on is this a good company? Do they make money? Are they profitable? Do you like the management team? All those good things.

Southwick: Does P/E ratio work particularly well for some industries vs. others? Like I feel like you wouldn't use a P/E ratio to understand a bank's profitability.

Gross: Yup. Exactly the right example I would have given. For financial, I tend to shy away from P/E ratios. In general, if truth be told, I prefer a cash flow metric. A cash flow ratio. The other two examples I gave are more cash-flow oriented. Earnings -- because of GAAP accounting like we discussed earlier -- can sometimes be a little misleading, so if we look at cash flow, instead, it takes away some of the wonkiness of GAAP accounting. It's a little harder to calculate. P divided by E is easier than figuring out enterprise value and EBITDA. But if you can -- you can sometimes get these metrics online calculated for you -- they're good to focus on.