Here is how to estimate fair value of stock before buying

When Baron Rothschild was asked how he had amassed an enormous fortune from the stock market, he replied, “I buy sheep (cheap) and sell deer (dear).”

The man clearly articulated the basic tenet of value investing - identify a value stock, compare its price with its fundamental factors and buy when you believe you are getting value for money.

Let’s start with the most common way to value a stock; the price-to-earnings (P/E) ratio. The P/E ratio equals the company’s stock price divided by its most recently reported earnings per share (EPS). A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.

But don’t get excited by rock-bottom P/Es - some companies are doomed to low valuations. Bamburi Cement, CIC Insurance and NSE stand at 12x, 9.17x and 12.31x respectively. All sit above the NSE 20 share index P/E which stands at 7.3x.

To quickly compare P/Es and growth rates, use the PEG ratio - the P/E (based on estimates for the current year) divided by the long-term growth rate. A company with a P/E of 24 and a growth rate of 10 percent has a PEG of 2.4.

In general, you want a stock with a PEG ratio that’s close to 1 (or lower), which means it is trading in line with its growth rate. But for a quality company, you can pay more. So with NASI’s PEG ratio currently standing at 0.9x, this is an indication that the market is undervalued relative to its future growth.

Just as investors like to know about a company’s growth rates, it’s also useful to know the price/Book Value ratio (P/BV). Defined simply, book value equals a company’s total assets minus its total liabilities and intangible assets. In other words, if you liquidated the company, this is what the leftover assets would be worth after paying off all creditors.

On the balance sheet, book value is represented as ‘’shareholders equity’’ - dividing this aggregate total by the number of shares outstanding will give you a per-share book value. Investors can use it to spot cases in which the market is over or undervaluing a company’s true strength.

Currently, stocks with P/BV below 1x include Kenya Re (0.2x), Co-op Bank (0.9x) and Jubilee Holdings (0.5x). Those with P/BV above Ix include Equity Bank (1.2x), Britam (1.1x) and Sanlam (1.6x).

All that said, is it true when they say that over periods of five years or more, stock prices closely track corporate profit growth? Does it hold true that the longer the stretch of time, the more important earnings trends are?

Does stock market gains come from profit growth? Do prices rise when profits add up? The simple answer is no. There is just no free lunch in the markets. So for the many (or few) valuation metrics used, the point is not to tell whether to buy or sell, they are merely a gauge to tell you whether a stock is overvalued or undervalued.

Yes, a stock’s ‘’intrinsic value’’ may be rooted in its fundamentals, but just because a stock (or sector) spots a discounted price, it does not mean a buy (and vice versa). In the end, the market will go where it feels like going.

The writer is managing director, Canaan Capital