Valuation Metrics: A Short Primer

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From a reader:

I only recently stumbled upon your blog, but I’m hooked.  I can’t thank you enough for taking the time to share your financial insight, experience and wisdom.

I’m a new entrant to the financial services industry (3 weeks on the job) and feeling ill-equipped without a finance degree. I’m struggling with the application of equity valuation. I’ve read several DCF valuation books and can recite all the valuation ratios, but I still have trouble looking at a companies financial statements and using them to make a judgement on a companies stock price.

Do you have any book recommendations for mastering fundamental equity valuation? 

Any help would be greatly appreciated. 

Any book by Aswath Damodaran on valuation, or Michael Mauboussin’s book on Expectations Investing will give you the theoretically correct view on how to value any sort of company.  Also, this book by James Valentine is very useful.

But I want to make your life easier.  Typically, by industry there is one simple metric that drives valuation at any point in time.  That typically gears off of the maturity of the industry, and its need for additional capital.  For those that are math nerds, there is the true model, but us lesser mortals can’t run it.  But each industry faces constraints that others don’t, and so the true model in a given industry becomes simpler to a first approximation: focus on price-to-sales, price-to-book, price-to-earnings, or the PEG ratio, among other ideas.

These simpler valuation measures focus on what is tough to do.  Can we sell more?  Can we increase our profit margin?  Can we grow our business more rapidly?

This is why sell side analysts in a given industry do not use the full valuation models listed above, but use a partial version of them, as is appropriate to their industry.

It’s useful to know the overarching model, as the above books will give you. But practically, every industry is valued differently, because each one faces different constraints, and that drives their valuations.

By David Merkel, CFA of Aleph Blog

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