How can you tell if a stock is “expensive” or “cheap”?

Question of the week

It is often said that tech companies are “expensive” on the stock market, while those in other sectors are “cheap.” This concept can be seen in the expression “value stock” which is used to characterize companies whose stock valuations are affordable. But what are the criteria that this assessment is based on?

There are several valuation methods. The most well-known consists in comparing a company’s annual profits to its market capitalization. This is reflected in the “P/E” or “PER” (Price-to-Earnings Ratio). A company whose stock market valuation corresponds to only five years of profits is considered to be very cheap. Meanwhile, a company whose value on the stock market is equivalent to 50 years of profits is undeniably expensive. In the long term, the average P/E of quoted companies is between 10 and 15 times their annual profits.

Other valuation ratios can be used, depending on the case. For example, the P/BV ratio allows you to compare a company’s market capitalization to its assets (book value). The EV/R (Enterprise Value-to-Revenue Multiple) has the advantage of being less volatile than the others. These two metrics can be applied to companies that are not yet profitable.

Still, using these ratios without putting them in context could turn out to be misleading. The revenue, profit, and assets of a company experience variations that investors constantly seek to anticipate. A fast-growing company will logically have high ratios, this “priciness” being justified by the quality of its future prospects. Meanwhile, a shrinking company could have low ratios, especially if its future is in doubt.

In short, judging a company’s price on the stock market requires both analyzing its current valuation and its dynamics. This is one of many criteria used to construct an investment portfolio capable of outperforming in the long term.

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The opinion expressed above is dated  13th May 2021, and liable to change.

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