Relying On Market Ratios To Gauge Valuation

Recently I came across some ValuEngine reports. Whenever I read any report, I like to know the author's basic valuation philosophy, as it helps me realize and sometimes improve my own methods. I've reprinted their valuation technique, with a little editing, as I find it quite interesting.

Portfolio managers and professionals traditionally rely on market ratios to gauge whether a stock is fair valued or overvalued. ValuEngine's valuation is based on one of three market ratios:

1) PEG (price to trailing 4 quarter earnings ratio, divided by the consensus analyst forecasted next year EPS growth)

2) P/E (price to forward 4 quarter earnings ratio)

3) P/S ratio (price to trailing 4 quarter sales)

Among the three, PEG is the most informative as it reflects both the price/earnings ratio and expected future EPS growth, while P/E is better than P/S.

For each given stock, ValuEngine applies the PEG to give a fair value assessment if both its trailing 4 quarter EPS and forecasted EPS growth rate are positive.

If its forecasted EPS growth is negative but its forward 4 quarter EPS is positive, they apply the P/E to give a fair value for the stock as of today. Otherwise, VE resorts to the P/S to assess its fair value.

To establish a valuation standard, they use both-

i) the average historical market ratio of the stock over the past 10 years (or however long there is data available for the stock), and

ii) the average market ratio today of five comparable stocks in the same sector and from companies of similar size.

These two alternative perspectives, according to VE, should give you a good idea about where a stock's valuation stands.