Ways to Evaluate A Company

Some investors may be wondering, between return on equity (ROE) and price earnings ratio (PER), which method is more suitable to value a company.

Warren Buffett said a good business should be able to achieve good ROE without employing high debts. Companies with high gearing are vulnerable to financial risk during the economic downturn and high interest rate environment. 

Besides, any future investment plans should be funded by internally generated cash flow without having to call on shareholders to contribute. Unless the return generated from the shareholders’ money is greater than ROE, it will show lower shareholders’ returns as a result of the enlarged share capital.

One of the biggest weaknesses in ROE method is that it does not take into account the current price of a share. A good company may show high ROE but its market price may be reaching all-time high. Hence, any investors who are solely dependent on the ROE method may be purchasing a stock at a very high price, which does not provide investors with margin on safety (MOS).

PER is defined as the market price of a company divided by its earnings per share (EPS). The principle behind this method is the concept of payback period. This ratio tells us how many times the price is greater than the annual earnings of a share. For example, Company A is currently selling at a PER of 15 times. This means that it takes 15 years for an investor to get back his returns

through the company’s annual earnings, assuming that the company will produce the same EPS during that period. 

Select stocks with low PER, but ?

First, we have to understand what causes a company stock to be sold at a low PER, where the market price is lower relative to its earnings. An unduly low price for a company may be due to the market’s failure to recognize its true earnings picture and potential. In this case, the company’s PER is usually far below the market PER. 

However, not all stocks with low PER imply good value for investing. As mentioned earlier, sometimes the cheap valuation may be a true reflection of certain negative aspects of the company, for example, poor corporate governance, high gearing, uncertainty of future earnings and or it is facing litigation.

However, as a result of asymmetric information, not all investors are fully aware of the market’s worries. Hence, analysts with the necessary knowledge, skills and market information play a very critical role in helping investors to analyze companies in detail and identifying those that are truly undervalued based on fundamentals.