Many investors or columnists on financial websites tend to focus much of their discussion on various companies on the valuation multiples ascribed to such companies by the market.
The idea that companies within a similar industry can be relatively easily compared by one number, and that this one number will provide a relatively decent depiction of how one company has performed compared to another is nice, however may not be entirely useful for a number of reasons.
First of all, metrics such as the price-to-earnings (P/E) ratio depict how a company’s share price is supported by its earnings. The theory goes that if the price (numerator) is high and the denominator (earnings) is low, then the company must be overvalued relative to its peers.
Investors may be shocked, then, to learn that Amazon.com, Inc. has a P/E ratio hovering around 190 and Ford Motor Company has a P/E ratio hovering around 12, although many investors would suggest that Amazon may be the better long-term pick over a more traditional company such as Ford due to the technology giant’s growth prospects over time, even though Ford maintains nearly twice the profit of Amazon currently.
The valuation of a company’s equity position can be valued in different ways, however a number of key assumptions play a role in any valuation model.
These assumptions include terminal growth rate (the company’s long-term growth rate), growth rates of income statement values over the next five years, discount rate, cost of debt and cost of equity (combined as weighted average cost of capital or WACC), as well as the company’s projected earnings, costs, and extraneous projects over the coming years which may impact the business’ stock price.
Valuation metrics are a start, but they aren’t everything.
Invest wisely, my friends.
