4 Ways To Value A Company

When it comes to stock investing, the share price is probably the most talked about factor. This isn’t surprising because, at the end of the day, the share price is the determining factor whether money is gained or lost. Furthermore, any entry into the stock market would require a certain capital amount which again, is determined by the share price.

So when first studying the share prices of a few companies, most people will be wondering why some shares are priced higher or lower than others. Let’s look no further than two widely known companies, Apple and Amazon. People often ask, hey why is one Amazon share selling at USD 3,500 and one Apple share is only going at USD 150? What do their share prices mean exactly? Does it mean that Apple is 20 times more undervalued than Amazon? Or is Amazon 20 times more expensive or more profitable than Apple?

That’s a good question actually which a lot of people might think it’s simple but in fact, it’s quite multifaceted.

The unfortunate thing is some investors use that single piece of information and buy the lower-priced stocks because it is just so intuitive to them. I mean why not, right. With a capital of USD 3,500, you will be getting around 20 Apple shares but just 1 single Amazon share. It’s like going to the market and buying more of what gives you more bang for your buck.

But investing is simple but not easy; difficult but not tough. You don’t need a high IQ to be successful but you need to be able to grasp a few important things. And if you don’t, you stand to lose it all. 

So is Apple that much “cheaper” than Amazon right now? Let’s compare a few selected data of the two companies to see what lies behind the prices of these behemoths. 

Metric (TTM)AmazonApple
Share price (US$)3,525155
1. Market Capitalisation (US$)1.8T2.6T
2. Price to Earnings61.530.4
3. Price to Sales4.07.6
4. Price to Book Value15.540
5. Price to Free Cash Flow255.727.9

Data extracted from gurufocus.com as at 09/09/21

Below we will look at each of the metrics shown in the table.

  1. Market Capitalisation

Formula: Share price x Outstanding number of shares

What it means: The total market value of outstanding shares in the company

Application (using Amazon as an example): There are a total of 507 million outstanding shares in Amazon and when you multiply this number with the market value of the share (US$ 3,525), you will get the current market capitalisation value of US$ 1.8T. 

  • Price to Earnings

Formula: Share price divided by earnings per share (EPS).of the company

What it means: The dollar amount an investor has to put into a company to receive $1 of that company’s earnings.

Application (using Apple as an example): The EPS of Apple is 5.11 and when you take the share price of US$ 155 divided by 5.11, you will get 30 times.

Note: EPS here can be obtained easily from finance sites however if you would like to calculate it yourself, simply take the annual net income of the company divided by the total number of shares)

  • Price to Sales

Formula: Market capitalisation (described in point 1) divided by total revenue.

What it means: The dollar amount an investor has to put into a company to receive $1 of that company’s sales.

Application (using Amazon as an example): The revenue (TTM) of Amazon is US$ 443B and when you take the market capitalisation of US$ 1.8T divided by US$ 443B, you will get 4 times.

  • Price to Book Value

Formula: Market capitalisation (described in point 1) divided by total net assets (assets minus liabilities).

What it means: The dollar amount an investor has to put into a company to receive $1 of that company’s net assets.

Application (using Amazon as an example): When you take the market capitalisation of US$ 1.8T divided by the net assets or shareholder’s equity of US$ 116B, you will get 15 times.

  • Price to Free Cash Flow

Formula: Market capitalisation (described in point 1) divided by the total free cash flow of the Company.

What it means: The dollar amount an investor has to put into a company to receive $1 of that company’s free cash flow. Free cash flow here refers to cash available after deducting capital expenditure.

Application (using Apple as an example): When you take the market capitalisation of US$ 2.6T divided by the free cash flow of US$ 92B, you will get 28 times.

Looking at the table, you can see that all metrics stated are relative to the share price. But what do the metrics and multiples mean? More importantly, which ones should we be using?

In comparing the market capitalisations of both companies, one would be rather shocked to see that Apple is more expensive than Amazon considering it has a much lower share price. This is because the share price is not the only variable here, the other lies with the ordinary share float in the market.

As for the price multiples (points 2 to 5), as a rule of thumb, the higher the multiple, the more expensive the stock is. And as financially savvy people, we should try to avoid expensive stuff, right? But as mentioned earlier, investing works in many different ways so you know the answer is well, not always. 

Based on the price to earnings ratio, investors are willing to shell out 60 bucks to make that dollar of earnings Amazon is making, whereas, for Apple, they are only willing to pay US$ 30. This means Amazon commands a price that is twice of Apple based on its earnings. However, it is the other way around for the price to sales ratio. Apple is two times more expensive than Amazon in terms of what investors are willing to pay for that dollar of sales. 

So should we use price to earnings or sales then? Or should we use free cash flow? Well, as we know by now, taking a leaf out of the out-performances of stocks which the media have over the years claimed to be overvalued looking at such ratios or performing DCF analysis etc, these ratios do not mean a lot when we come to think of it. Granted, they do give a good snapshot of how the market is valuing the company. And these may still work for certain companies but it is up to us investors to decide whether it is worthwhile to get the more expensive one or we are good with the cheaper one. Furthermore, there are other considerations be it quantitative or qualitative to make when assessing a stock. 

The process of share investing should be simple and enjoyable but it should not be simplified to the extent of using only mathematical formulas to make investing decisions. If that’s the case then, we retailers have probably a zero chance of beating other people or organisations as they will have more resources or a more sophisticated tool or a machine to out-calculate and out-manoeuvre us. But the good news here is if investing were that easy and just based on number-crunching, mathematicians or statisticians will easily be the richest people in the world. The last time I checked, they are not. That means figures and ratios are just one aspect of stock investing. It is important for us to know how to value a stock. We have went through 4 simple method in this article. However, we need to know that valuation is not the only factor we need to consider when making an investment decision.

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