Valuation allow us to understand the value of a stock/counter and avoid in purchase overprice stuff.
Anyway, valuation strategy is quite depend on investor's risk appetite and target profit.
Important : This topic share about Valuation (not include stock pick, please don't make any stock purchase solely depend on this article.)
For stock pick strategy please refer to here
2 important indicators for Growth Stock?
First, let understand the 2 valuation Indicator that related to Growth Stock - PS (Price to Sales) and PE (Price to Earning Ratio).
- PS (Price to Sale Ratio)
- - The formula for PS can be either "Share Price / Revenue Per Share" or "Market Capital / Total Revenue".
- - This indicator best suit for high growth company who not yet achieve any Profit but have great Revenue growth for a few period.
- - Not all company can immediate make profit after listed, especially Technology firm. Because technology firm early stage require high setup cost for the infrasture , software development cost and so on. Thus early stage, we can see these kind of company revenue growth ratio is much faster than profit growth(some company even suffer in loss). Thus PS come very handy to evaluate these kind of company.
- - For PS, there is not fix value to follow. Normally I will take 3-5 year PS of the company as standard, let say the company pass 3 year PS stay around 8 - 15, then i can make assumption that below 8 is undervalue while between 10 -12 is fair value. Never use PS on Stable Company/ Dividend Company because their Revenue had stay stagnant. I would say PS best suit small capital and high growth firm.
- PE (Price to Earnings ratio)
- - PE can be calculated either "Share Price/ Earning Per Share" or "Market Capital/Total Profit".
- - Unlikely to PS, PE formula is calculated base on Earning, so this indicator is suitable for company who have stable and consistent profit.
- - Avoid to use PE on cyclical counter like Commodity stock (Plantation, Steel) or Hotel. This is because PE will be not accurate. When Non-Peak season PE will extreme high and the other way during peak season. Anyway I don't really encourage to buy cyclical stock unless you very familiar with that industry and able to discover the trend.
- Same like PS, for PE there is not fix value to follow. I will take 3-5 year PE of the company (or take Average PE from a few company that same industry) to evaluate. Lower PE normally indicate the counter are undervalued now (but to be safe need study why PE get lower).
How to do valuation for Growth Stock?
- Study the history PE or PS of the company to get average PE or PS (we can get average PE / PS for company in same industry as well).
- Wait for PE / PS drop below the average and study why.
- Avoid few condition that will cause false indication on PE or PS.
1. Study the history PE or PS of the company to get average PE or PS .
Normally i will work on growth company for this. (revenue or profit consistent increase for few year). First calculate the PS or PE for 3 - 5 year. Let say 9, 10, 12,11 and 13. In this case i will choose 11 as Fair Value. Then I will reverse the formula to calculate the Fair Value Share Price.
Let say current EPS is 30 cent, 11 is my Fair Value PE or PS, then Fair Value = 0.3 * 11 = 3.3. So i will set an Price Alert on 3.3 and wait for it to triggered.
Note: Whenever met extreme value for historical PE or PS, we need to adjust it. Example 9, 10 ,25, 12, 11. In this case, i will remove 25 as this extreme value will make average PE or PS not accurate.
2. Wait for PE / PS drop below the average and study why.
Don't buy immediate after the PE and PS drop below our selected threshold. Find the reason first to make sure not due to one time cause and long term fundamental issues. PE or PS formula include Price , Revenue and Earning. So whenever PE or PS drop, it definitely is either Share Price drop or Revenue and Earning increased.
If share price drop, below are thing we need to observed:
- Is it Share split or bonus issues happen? If yes, please re-calculate the new average PE or PS.
- Is it long term fundamental impact happen? If yes, please re-evaluate the whether should cut loss or not.
Not all scenario that cause Revenue and Earning increase are good thing, please refer to point 3.
3. Avoid few condition that will cause false indication on PE or PS.
Below are few condition that will cause PE or PS not accurate and we need to exclude it when doing evaluation:
- One time Profit or Revenue by selling company Asset.
- - As this is one time profit and only happen once in the blue moon, we need deduct the profit or revenue from this one time gain to get accurate PE or PS.
- - Example : Air Asia selling the aircraft.
- Company Boost Revenue or Profit using Debt.
- - Let say a zero debt company decide to borrow more debt and setup more branch to boost the sales. In this scenario, we need to evaluate back the Stock Pick strategy to see whether should we continue holding this company? Because this is common tactic that company like to use for rapid expansion, high debt company normally have higher risk when unexpected situation happen. Example Covid-19.
- Frequent Share Buy Back
- - Share buy Back mean Company buying back their own Public Share. When this scenario happen, number of public share will decrease, thus EPS will increase but in fact the company profit capability had not increase at all. Since EPS increase, thus PE will lower.
- - Remember, we looking for Company who grow rapidly not looking for Company who use Share Buy Back to make figure nicer.
Once confirmed the PE or PS decrease is not due to permanent fundamental factor, then I will purchase my very first batch. Same like dividend play, I always split my fund to 3-5 batch making stock purchase, this is to allow me to balance down and get better price.
Summary : PS and PE are only 2 of the many valuation that can use for Growth Stock valuation and each of them can be improved by using Forward PE, PEG or even improved the average formula using Moving Average PE or PS. What i cover here is very basic concept on PS and PE only.