This is how you can use relative valuation multiples to find the best investments

This is how you can use relative valuation multiples to find the best investments

24 September 2018 from Mikael Syding

How did you find your latest equity investment? Did you buy the same thing as a friend who was already in the money on his investment, who said it was a "good share" and a "nice company"? Be honest now. There is nobody who judges you except yourself.

Did you read an analysis from a bank where they recommended "Buy" and with a target price for the stock that was significantly higher? Can you explain their reasoning, or were you just impressed by the claimed potential?

Or did you make your own investigations and made a decision where you understood both what you knew and what you did not know? Do you even know the analyst who made the recommendation? How accurate have previous analyzes been? How solid have the reasoning been? How clear and convincing were the arguments in this case?

A combination of all of the above can often be good when looking for investment options, ie use multiple sources of inspiration for stocks to watch. But keep in mind that you should do the analysis yourself. Do as much as you can; It does not have to be perfect, but if you put some energy to avoid the simplest mistakes then decisions will gradually get better. If you know why you invested then you can also analyze what went wrong and wrong and adjust your method accordingly.

Here is a proposal for a process for filtering investment ideas that will often yield a good return - but not always, because such processes do not exist:

Start from a group of companies you think could be good investments. It can be based on tips from knowledgeable and credible individuals or analytical firms; or something as simple as the largest companies in a particular region (eg OMX 30), or a number of companies in a particular industry (maybe Betting, Biotech, Banking, Food, Clothing or Manufacturing) you have reason to believe may generate good return.

Then filter out the shares that do not meet your requirements. These may include factors such as profitability, growth, dividend, size, stock turnover and the like. One of the most common filters is valuation, but the valuation needs to be put in relation to something to know if it is high or low, ie if the stock is expensive or cheap.

Many people use different so-called profit multiples when assessing the valuation level, such as P / E or EV / EBIT. These profit multiples describe how many annual earnings you pay for the share. A multiple of 40 means that it takes 40 such annual profits to get back the money for which you bought the share.

One problem with such profit multiples is that profit margins can vary considerably over both business cycles and product cycles. Price / Sales is a more stable valuation measure, or even EV / S that takes into account the company's debts - but it may be a little outside the scope of this post. Unfortunately, the P / S ratio has the disadvantage that it is more or less locked to the specific company, so you can not say in advance if, for example, P / S 3.0 is expensive or cheap - even if you know other companies are trading at 2.0 or 4.0. It does not even help compare with companies in the same industry, as every company has different profitability conditions (a company that has a 3 percent profit margin over a cycle justifies ceteris paribus a much lower P / S than a 10 percent profit margin company).

However, there is a way that works well: History-related P / S numbers, ie, how close their own historical outlines for the P / S share are traded today.

If a share has historically traded at a P / S ratio of between 1.5 and 3.0, with a relatively even distribution in the range, then a multiple of 3.0 would definitely be a cause of caution and further analysis. Ask yourself why. Is it because of unjustified hype, or is it perhaps the target of a take-over? It is therefore not obvious that a high extreme rating means that it is a good selling position.

Also note that if it is handled close to the lowest level in the interval, one must be just as thorough. Sure, if nothing has happened in particular, the stock may be temporarily cheap and may be rising again, but it may also be that more knowledgable investors have a reason to sell now rather than later. Perhaps more competition or unfavorable legislation is waiting around the corner. The market is often good at specifying this information in advance.

Thus, filtering on extreme values is only a starting point for finding interesting situations, and not least one way to reduce the number of objects to analyze seriously.

A little unexpectedly, it may often be that valuation multiples in the middle of an historical range can be interesting. There are no big hopes or panic in the course. Fewer ones may be interested in an average-value share, and as an amateur with limited time for analysis, it may be safer land with less risk of major mistakes. If the stock has spent most time around, for example, P / S 2.2, it's no stupid guess to believe it will be there in when hot sometime in the future too.

And if the company grows with the economy in general, or a little faster, you'll partake in that growth, albeit without the extra potential that a valuation increase would provide. Best of all, if you have a more or less confirmed idea of the state of multiple. Assume that the range has been 1.5 to 3.0, and that the valuation moved in fairly stable trends or cycles from one extremist to another, perhaps in line with macro factors such as inflation, interest rates, currencies, GDP or labor market statistics. If today's valuation is 2.0 and it's relatively recently down to 1.5, and that macroeconomic measurements, or the company's product cycles, confirm the pattern of an upcoming improvement, then you have a great opportunity to buy.

So: start with a group of companies. Filter on a valuation multiple that has worked for you before - e.g. low P / S numbers may work well under certain circumstances. Compare primarily with thecompany’s own valuation history, that is, the range that the company has traded in recent years) and decide if you want to examine low, high, or average-valued companies. Then try to find out if there is any obvious reason for the valuation's deviation from its average. How do the shares you already own look? Is Hennes & Mauritz P / S-multipel the lowest it has been? Does it mean that it is cheap, or are there other explanatory factors? What does Assa Abloy look like? Hexagon? Atlas Copco? Catena Media? Danske Bank? Danske Bank’s valuation multiples are extremely low right now, but it is also due to very negative information about money laundering in large scale.

No matter which companies you own, it is a good practice to find out if they are "cheap" or "expensive" right now relative to their historical ranges. If you do not have a good explanation for why, then it's a signal to consider actions to protect your portfolio, or perhaps to increase your exposure. Lastly, compare your holdings with similar stocks you do not own and investigate if they actually are undoubtedly better choices. If they are not, change!

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07/12/2022 18:53:36


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