This article provides an excellent overview of how investment analysts value companies and the role diversification plays in investing. Here are the key takeaways:
Valuation Methods Used by Analysts
Investment analysts rely on a variety of tools to evaluate the "fair value" of a company, often leading to "buy," "hold," or "sell" recommendations. The most common valuation measures include:
P/E Ratio (Price-to-Earnings Ratio)
Formula: Current Share Price ÷ Earnings Per Share (EPS).
Usage: Indicates what investors are willing to pay now for a company based on its past earnings.
A high P/E might signal overvaluation (or expectations of high growth), while a low P/E suggests undervaluation.
PEG Ratio (Price/Earnings to Growth Ratio)
Formula: P/E Ratio ÷ Future Earnings Growth Rate.
Usage: Incorporates future growth expectations, offering a more dynamic valuation compared to P/E alone.
A low PEG may suggest the stock is undervalued relative to its growth potential.
ROE (Return on Equity)
Formula: Net Income ÷ Net Assets.
Usage: Measures how effectively a company uses shareholders' equity to generate profits.
A high ROE typically reflects efficient management and profitability.
Free Cash Flow (FCF)
Definition: Cash remaining after covering operating and capital expenses.
Usage: High FCF indicates strong financial health and potential for reinvestment or dividends.
Subjectivity in Valuation
Even when analysts use the same quantitative tools, their conclusions may vary due to subjective judgment. This explains the range of share price forecasts for the same company.
Diversification: An Alternative to Stock Picking
For those who find individual company analysis overwhelming, diversification offers a simpler and effective strategy:
Managed Funds and ETFs
Instead of betting on a few companies, these funds spread investments across many companies, reducing risk.
Index Funds
Track market indices, investing proportionally in companies based on their market capitalization.
Pioneered by John C. Bogle, index funds are celebrated for their long-term returns and reduced portfolio risk.
Conclusion
Whether using individual valuation measures like P/E or PEG ratios or opting for broad diversification through funds, the right approach depends on your investment goals, risk tolerance, and willingness to engage in analysis. Diversification, however, remains a robust strategy for mitigating risk and achieving consistent returns.
Rick Maggi CFP, Financial Advisor (Perth), Westmount Financial
____________________________________________
Disclaimer
This document has been carefully prepared by Westmount Securities Pty Ltd (ABN 42 090 595 289, AFSL 225715) for general information purposes only. However, neither Westmount Securities Pty Ltd nor any of its affiliates guarantee the accuracy or completeness of any statements contained herein, including any forecasts. It is important to note that past performance is not a reliable indicator of future outcomes. This material does not consider the specific objectives, financial circumstances, or needs of any particular investor. Therefore, before making any investment decisions, investors should assess the relevance of this information to their individual situation and consult professional advice, taking into account their unique objectives, financial position, and needs.