Tuesday, 8 September 2015

When to use P/E, P/B, EV/EBITDA

These are the 3 main valuation tools that people use when trying to quantify the value of a stock. But people have been applying the wrong tools to the wrong type of stock.

For example, if you apply P/E to Olam or Capitaland (during certain years) and the stock looks ridiculously cheap which may result in you buying the wrong stock and the wrong time.

P/E - (Price to earnings)
It can be seen as how may multiples are you willing to pay for one years worth of earnings (earnings per share). This is the most widely used multiple which is used for companies with constant earnings, which can be found by seeing whether your stock falls under any of the 3 categories below
  1. make money by selling inventory
  2. Has a 'moat' in a mature industry
  3. provide constant services

Make money by selling inventory
This is probably the easiest way to tell whether the firm should be valued by P/E. As firms that have sell investor mainly have consumers as their customers, their earnings are generally quite stable which allows for a proper P/E calculation

Stocks include: Thai Bev, Breadtalk, Super Coffee, SPH, Osim

Has a 'moat' 
This usually ensures that their customers are captive and that the businesses are in a monopolistic position which allows them to generate constant earnings

Stocks include, SGX, Dairy Farm, Comfortdelgro

Provide constant services
Same logic as selling inventory

Stocks include: SIA engineering, ST engineering, kingsman, silverlake, Raffles Medical

Even such the P/E for all these companies shouldn't be compared to one another (For example Osim P/E is about 14x while SGX is 20+)

In general the more resilient the stock is to downturns + the larger its moat the higher the P/E

So F&B stocks with a good brand name (Thai Bev), Medical stocks which are resilient to downturns and have a moat (Raffles Medical) can easily trade up to 20x. 

P/B - (Price to book)
The multiple that you are willing to pay for the book (net asset value of the firm). This is mainly used for firms that rely on their book (net assets) to generate profits.

These firms usually make rely on their long-term fixed assets to make money. This is unlike firms that use P/E where they rely on the stuff they make/services to earn.

This involves having a expensive/huge asset that the firm mainly relies on to generate its earnings, or a backlog it has  (projects that the firm won but will take 5 years to complete) which can be converted to earnings in the future.

These stocks include

Airlines -  Earnings rely on how many planes they have
Offshore & Marine - Itt takes 5-10 years to fulfill an order, hence a huge backlog that can be converted to earnings
Property  - Firms have properties that aren't launched and a 'land bank' which can be developed into future profits
Banks - The loans (assets) on their books is how they generate profit
Commodities - Your number of plantations will determine your potential earnings

Here's the shocker, in general most firms are supposed to trade at a discount to P/B (except for banks). So everytime you see a stock that has 0.8x P/B please don't rush in and buy it. The reasons are..

Airlines - Planes have a high depreciation (asset value drops), so your P/B won't look that attractive after some time. Also, airlines don't make any bloody money wth.

Offshore & Marine - Oil drillers have a right to cancel/delay their orders, which means lets say if Keppel Corp has 5billion worth of orders they can deliver over the next 5 years, it may shrink to 3 billion of orders stretching out to 7 years. (Which is whats happening now)

Property - Property that aren't launched doesn't mean it will get 100% sales. Also the cost of land bank + developing the land may be less than the total profit that could be earned from the property. 

Banks - Some loans may default, but since SG banks have a low default rate, they usually trade above book 

Commodities - Firstly, who the hell can predict the weather, how good the harvest will be and the exact number of cows, farmland, plants, trees, coca does the firm actually have?

EV/EBITDA - (Enterprise value to Earnings before Interest, Tax, Depreciation and Amortization)
To be honest, only people the want to look all sophisticated use this when valuing a stock. Anyway its mainly used for companies that have high start up costs and then have very little costs afterwards (and can afk while making money)

Generally used for telcos and casinos, where you spent a huge amount of cash building up a network or casino, and life after that is pretty much on autopilot.

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