I AM writing this from 30,000 feet on a plane ride back to Singapore. An orange and pink sunset shimmers in the distance while banks of clouds stretch out as far as the eye can see. It is an appropriate moment to discuss the lofty, sometimes airy-fairy, idea of stock valuation.
People pick and buy individual stocks because they believe they can calculate how much a stock is really worth. In their minds, this intrinsic price is invariably higher than what they bought it at.
Equity analysts, too, set a "target price" or "fair value" for a stock they set their eyes on. Every day, we see report after report peddling a "buy" or "overweight" call on a company, because the target price of the stock is, say, more than 15 per cent above what it is currently trading at.
But how do you go about calculating how much a stock is worth?
Which method is the best? And the million-dollar question is: Are these methods accurate?
Today's article will introduce a couple of methods you might read about in stock reports. Future articles will expand on the topic, which is too big to be covered in a single day.
Knowing how stocks are valued will allow you to question whether the method used is the most suitable, or whether the assumptions used are correct.
Expected dividend yield
For investors who put their money in stocks that pay dividends, a back-of-the-envelope way of valuing a stock is to examine the dividend it is paying as a percentage of its current market price, and think about what yield the market is willing to accept.
The analyst sets a target dividend, a target dividend yield and calculates the stock price accordingly.
Take for example a May 23 report on engineering, property and manufacturing company King Wan Corp by broker DMG & Partners. DMG expects King Wan to pay a 1.5 cent dividend in the current financial year, rising to 3.0 cents in the financial year 2014.
A 3.0 cent dividend on King Wan's share price of 31 cents as of the report would translate into a rather high 9.7 per cent yield.
DMG does not expect this state of affairs to last. It said some "yield compression" beyond a yield of 7.5 per cent is possible, meaning that as the share price goes up, the dividend yield on the stock will go down.
It set a target yield of 7.5 per cent. To yield 7.5 per cent on a 3.0 cent dividend, the target share price of King Wan will be 40 cents.
This is calculated by dividing 3.0 cents by 7.5 per cent.
Valuing a stock by expected dividend yield is useful only if forecasts of the dividend payout by the company can be accurately made.
Real estate investment trusts (Reits) can be valued like this as they are required to pay out 90 per cent of their distributable income, and their earnings can be predictable.
One can also value blue-chip companies with a stated dividend payout policy and a stable growth trajectory.
But what expected dividend yield do you use?
This is when stock valuation becomes more of an art than a science.
The yield of a stock represents the risk that investors are willing to take. Riskier stocks trade at higher yields, because investors need to be paid more to take on higher risk.
DMG's 7.5 per cent expected dividend yield of King Wan is considerably higher than the 3 to 4 per cent dividend yields that blue-chip stocks such as the local banks trade at.
This is because King Wan is considered a small-capitalisation stock. It has a market value of US$85.7 million as at the report, compared to billions of dollars for the large-cap stocks.
Smaller stocks often have lower revenues and smaller-scale businesses. They borrow money at higher interest rates. They are more vulnerable to economic cycles and in times of crisis, may not be able to find institutions to lend them money.
Investors thus take bigger risks by investing in small caps, and need to be compensated accordingly.
Why do you use 7.5 per cent, instead of say, 8 or 9 per cent? DMG did not reveal its assumptions in the report, but there is no hard and fast rule.
You can take an average of the yields that similar small-cap stocks such as King Wan trade at.
You can also take the average yields that blue chips trade at, and add a predetermined three or four percentage points to that.
Needless to say, a small change in an assumption can result in a big swing in target price. For example, on a 3.0 cent dividend, King Wan's target price would be 50 cents if the expected dividend yield was 6 per cent instead of 7.5 per cent - a full 25 per cent more than the 40 cent target price.
On the other hand, if you decided that small-cap stocks are too risky in the current environment and investors need to be compensated 9 per cent for buying them, then King Wan would trade at 33 cents - 17.5 per cent below the 40 cent target price.
Evaluating dividend yield method
Not every company can be valued by its expected dividend yield.
Fast-growing companies might not pay out any dividends for quite some time, preferring to plough their profits back into the business.
Their dividends can also grow very fast. You will need to incorporate a growing dividend payment into your model.
A single calculation based on a static dividend payment will not do. In a future article, we will examine a valuation model that assumes constantly growing dividend payments, called the Gordon growth model.
Even if dividend payments do not grow, remember that dividend yields are just a function of a company's price, and prices can fluctuate wildly, making the model a poor predictor of stock prices. Dividend yields can be pushed far below or above what one would otherwise reasonably expect in times of irrational exuberance or financial crisis.
You would have to revise your expected dividend yield target in these circumstances. If the market is in a bullish mood, it will accept a far lower dividend yield on its favourite stocks.
If investors are feeling bearish, stocks are likely to trade at higher dividend yields.
Dividend payments are also not guaranteed. A company makes the decision to pay them every year, which shareholders then approve. A company that is not doing well will cut its dividend payments, throwing the valuation calculation into disarray.
We now go to one of the most common ways to value individual stocks.
This is the earnings multiple model. Simply put, the analyst sets a multiple of the net profit a company is expected to make this year, and gets the target price from the total sum.
For example, if a company is expected to earn five cents a share for investors this year, and the analyst sets a multiple of 12, the company is calculated to be worth 60 cents a share.
This means the company's profit added up over the next 12 years will pay for one's purchase cost.
In a May 20 note on local supermarket group Sheng Siong, DBS Group Research upgraded the stock to "buy".
"Following our earnings revision, we now value SSG at a TP of S$0.76 based on 25x FY13F earnings," DBS wrote.
In plain English, this means that Sheng Siong, then trading at 66.5 cents, is being valued at a target price of 76 cents. This price is derived by multiplying its expected earnings for the financial year 2013 of about 3.0 cents a share by 25 times.
Why value a company based on its earnings?
Earnings, or net profit, are the most important line in financial statements that the investing community examines every quarter.
They are the easiest way to make a snap judgment about how well a company is doing and how much it should be worth.
The problem with this model is that earnings change from year to year.
A fast-growing company might earn five cents a share this year and seven cents a share the next. Setting an arbitrary multiplier on this year's earnings will undervalue the stock if it will earn significantly more next year.
Analysts get around this by using next year's predicted earnings, as well as setting higher multiples on fast-growing companies.
How does one arrive at a multiple? Why is ShengSiong valued at 25 times instead of say, 20 or 15?
Again, this depends on the peer group the company is being compared to.
To get a suitable multiple, analysts look at the historical multiples which similar companies have traded at, as well as the multiples that comparable companies are currently trading at.
The reasoning is that similar assets should trade at similar prices. By taking an average of the multiples that comparable companies are trading at, one can arrive at a suitable multiple to use.
Today, we have discussed two methods used to value stocks: by expected dividend yield and by earnings multiples.
There are many others that we will examine another time. These include valuation using other multiples, using assets, and discounted cash-flow models. Hybrid models use a combination of methods.
Stock valuation methods are just a guide to how much a company is worth. A small change in assumptions can result in a large change in target values.
By using different models to arrive at a target price, you are more likely to find out whether your assumptions are realistic or accurate. You should also test your model's sensitivity to changes in input factors to see how prices fluctuate.
A company may take years to reach your target price. In this case, either the market is wrong, or your model is too optimistic.
Ultimately, stock valuation is a notoriously imprecise science and is just one among many ways to decide the value of a company. All it takes is a few market fluctuations to bring an investor quickly back down to earth.