Find good value stocks with these magic numbers

If you're looking for value, you need to consider more than share price - you need a valuation gauge. MoneyWeek explains the workings behind the 'magic numbers' proving most popular with investors.

A share with a low price isn't necessarily cheap, as Peter Temple points out in his guide to valuation measures, Magic Numbers (John Wiley & Sons, £22.50). To distinguish between price and value, and compare firms to their rivals and the overall market, investors need to relate the share price to various measures of financial health, such as earnings or sales. The following are among the most popular valuation gauges.

Valuation gauge #1 Price/earnings ratio

The main measure analysts use to determine a firm's value, the price-earnings ratio (p/e or PER), relates a company's market value (its market capitalisation) to its post-tax profits. It is calculated by dividing the market cap by after-tax profits, or the share price by earnings per share (EPS). P/es can be calculated on a trailing or historic basis by using the EPS from the group's most recent reporting period; or on a forward (or prospective) basis, using the estimated EPS for the current financial year. Index compilers publish p/es for sectors and the market as a whole, so individual stocks can be compared to their peers and the overall market. The lower a p/e the cheaper a stock, but this might not signal good value. A firm may have a lowish p/e due to limited growth prospects, while a high-tech company could be on a high p/e but still be good value if it is growing quickly.

Valuation gauge #2 Price/earnings to growth ratio

To get a handle on whether a firm's earnings growth justifies its price, use the price/earnings to growth or PEG ratio. This is the forward p/e ratio divided by the (consensus) forecast earnings growth rate expected this year. A firm with a p/e of 100 and an earnings growth rate of 50% has a PEG of two, while a firm with a p/e of 20 and a growth rate of 15% would have a PEG of 1.33, making it cheaper relative to its potential earnings growth. A PEG of less than one is generally deemed cheap. The measure works best when comparing fast-growing companies.

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Valuation gauge #3 Price/sales ratio

A popular alternative to the p/e ratio, the price/sales ratio (PSR), or price/revenue ratio, is applied when companies are not making a profit; long-term studies in fact suggest that PSRs are a better predictor of high returns than low p/es. The PSR is the market capitalisation divided by trailing sales, or revenue over the past year. A PSR of one is deemed cheap, but it works best when comparing industries that have similar profit margins; firms with low margins usually have low PSRs, as sales cannot be converted into profits so easily.

Valuation gauge #4 Price/book-value ratio

Book value can be found on a balance sheet under the heading shareholders' equity or net tangible assets the value of the net assets attributable to shareholders. It is all fixed and current assets minus long-term and current liabilities (debts). The share price divided by the book value per share is the PB ratio. A PB of one or below tends to be considered cheap, but it only really works when comparing capital-intensive businesses. As book value ignores intangible assets, such as brand value, it means little for service-based firms with few tangible assets.

Valuation gauge #5 Dividend yield

This expresses the total value of the earnings a firm pays out in cash to investors in a certain year per share, as a percentage of the share price. The current share price divided by the estimated dividend per share for the next financial year is the prospective yield; the current price over the dividend per share based on the latest completed financial year (or on the past 12 months) is the trailing yield. Generally, the higher the yield, the cheaper the share, but an unusually high yield usually means a share has been marked down in the expectation of a dividend cut. Check a firm's dividend cover (quoted in the FT's Monday share listings) to establish to what extent profits cover dividend payouts: a ratio of more than three is usually thought secure.