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Investment strategy uncovered: How to check a company's valuation

by , 02 January 2015

When it comes to analysing a company, its share price is very useful. Using it along with the latest annual report and you can find out what the stock market is saying about a company's future prospects.

By doing this, you can reduce your risks of paying too much for a share and find possible undervalued ones.

Sometimes you'll come across stocks with share prices that imply they won't grow their profits. It's when you come across stocks like this that you may have found yourself a bargain.

So how can you check?

Read on to find out…

Using earnings power value to check if you’ve found a bargain

Professor Bruce Greenwald of Columbia University developed earnings power value (EPV) to check this. He based it on the philosophy of value investors Benjamin Graham and David Dodd.

EPV calculates the earnings power of a company by studying its profits over a lengthy period of time and estimating future average profits. It does this by looking at likely business conditions.

This estimate is then capitalised by the rate of return you believe the company needs to offer investors to give a valuation of its current earnings, Phil Oakley in Money Week explains.

You can then compare this to the current share price to see if the company is over- or undervalued.

You can break a company’s valuation into two parts:

  • The value of its current profits; and
  • Your expectations of how its profits will grow.

If you uncover a stock that’s trading for less than its current earnings alone are worth, it could be a potential investment. The key thing is checking if the business is in a long-term decline.

Six steps to follow to check a company’s valuation

Instead of using a long-term estimate of earnings power, you could opt for the company’s current level of profits if you think they’re sustainable.

Here are the steps to check a company’s valuation against its share price:

  1. Take the company’s most recent annual operating profits.
  2. Tax this at the company’s full tax rate so you’re on the conservative side.
  3. Divide this by your required return to get the EPV.
  4. Minus any debt or pension deficits. Then add any cash balances to get the value of the company’s equity.
  5. Divide this by the number of shares to give you a per share value.
  6. Compare this with the current share price.

You’re looking for a much higher EPV than the company’s current share price.

So there you have it, how to check a company’s valuation.

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Investment strategy uncovered: How to check a company's valuation
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