Price Earnings Ratio and Price Book Value

Price to Earnings Ratio (PER) is one of the most basic measurement of the fundamental analysis. In simple word, PER is a 'comparison between the stock price with net income of the company', in which a company's stock price is compared with the net income generated by the company within a year. Because the focus of the calculation is the net profit that has generated by the company, then by knowing the PER, we can find out if the stock price is considered reasonable or not in real terms and not just in form of a speculation or estimation in the future. Okay, let’s get on with it.

Calculating PER is very easy, even your son or daughter in elementary school can do that. It is done by dividing the share price by its earnings per share (EPS) of the company that is displayed on the company's recent financial statements. For example, Adaro Energy’s (ADRO) stock price by time this article was written is 1,990. EPS of ADRO in its First Quarter 2010 financial statements is Rp26.9 per share. Because Rp26.9 is ADRO’s EPS in one quarter (3 months), then its EPS should be annualized first by multiplying it by four (3 months x 4 = 12 months = 1 year), so the result is 26.9 x 4 = Rp107.6 per share. Therefore, PER of ADRO is 1,990, divided by 107.6, and the results is 19.1 times. Thus, we can say that 'ADRO’s stock price is 19.1 times of the company's generated net profit'. The greater the PER value of a stock, the more expensive that stock will be.

So, let's say that stock X's price is 1,000, while stock Y’s price is 500. It looks that stock X is more expensive than stock Y, isn’t it? But if the PER of stock X is only 10 times, while the PER of Y stock is at 20 times, then it is clear that: fundamentally, stock X is doubled cheaper than stock Y.

Note: EPS is derived from net income divided by number of the outstanding shares. For example, ADRO, its net profit on First Quarter 2010 is amounted to Rp861 billion. Because the number of the ADRO’s outstanding shares in the market is 32 billion pieces, then its EPS is 861 divided by 32, and the result is Rp26.9 per share. However, you do not need to calculate the EPS because it usually has been shown in the financial statements.

Sometimes there are two EPS on the financial statements, namely 'basic EPS' and 'diluted EPS'. If so, then take the ‘diluted EPS '. What does that mean? Diluted EPS is calculated based on the latest number of shares, because the number of outstanding shares of a listed company may change from time to time, due to the rights issue and others.

Because the price of a company's shares are always changing every moment, then the PER is also able to change at any time. Every time the company issued its latest financial report, then the EPS that is used as the basic calculation must also be replaced.

Then, how to use this PER to say whether the price of a stock is low, fair, or high? When you get the ADRO’s PER at 19.1 times, what does that mean? Does that mean that 1,990 of ADRO’s shares is considered as low, fair, or high?

There are two ways to assess the reasonableness of a company's stock price after PER values ​ known, which is by comparing it with other companies in the same sector of the class, and by looking at the performance of listed companies in the past.

For example, PER of ADRO based on latest share prices and financial reports in First Quarter 2010 was 19.1 times. We know that ADRO is a coal company, then we have to compare PER of ADRO with PER of ITMG, INDY, PTBA and BUMI. Apparently, PER of ITMG is 16.4, INDY is 12.4, and PTBA is 26.9 (BUMI has not issued its financial statement in First Quarter 2010). Thus, we can say that the PER of ADRO at 19.1 times is relatively expensive, so its chances to strengthened are relatively small. But you can’t compare PER of ADRO with PER of DOID, although both companies are the same coal company. Why? Because ADRO is already well established as a coal company, while DOID is considered as newbie in this field. So of course we cannot compare the results of the work between the ‘adults’ and ‘youths’.

It's still a relative conclusion. And how to be sure? It can be done by looking at the track record of ADRO in the past. In Full Year 2009, ADRO generated Rp4.4 trillion of net profit that rose awfully lot, if compared while it was in 2008, which were only Rp887 billion. However, in previous years (2007 and earlier), the net income of ADRO is still very small. ADRO achieved significant improvements just in 2009, which turned down again in First Quarter 2010. Well, because in the long run ADRO still need to prove that they are a profitable company, then PER of 19.1 is clearly too high. As a result, we can conclude that the price of 1.990 of ADRO is fundamentally high.

Although the conclusions obtained from the calculation of PER only, but its accuracy can be justified. And that accuracy can approach up to nearly 100% if you are able to combine it with other calculations. That's why I wrote on last 1 May that the share price of ADRO, which at the time was in a position of 2,200, could not rise even higher and likely will weaken. Here’s the link. In addition, in fact, up until today, ADRO has not been able to break the points of 2,200 again.

If the performance of a company is good or excellent, although the PER is high, the share price can be still quite reasonable. For example, UNVR, which became the only bluchip with PER above 30 times. Even though it seems that the stock price is very expensive, but because of the company’s performance is nearly perfect, and it is one of the companies who often give out its dividen in big portion (sometimes even reach up to 100% of net profit), then UNVR’s price that is generating 30 times of PER is considered reasonable.

What if the company’s PER you have counted was not moving particularly in certain sector? For example like ASII that engaged in many sectors? You could compare it to the same-class company, although the company plays in other sectors, for example TLKM, BBRI, ISAT, or other bluchips. The point is, in the same class! Apple to apple!

If you have the experience, then once you know the PER of a company, you can directly assess whether the stock price is considered as low, fair, or high, without the need to compare it with other PER of other companies, or looking at the company’s track record in the past.

Price to Book Value (PBV)

PBV is basically the same as PER. The difference is, if PER focuses on the company’s generated net income, PBV focuses on the equity value of the company. PBV, according to its name, means 'share price compared to the value of equity per share'. The way to calculate it (I’m sure most of you have already know), is by dividing the share price by its Book Value (BV), where the BV is generated from equity that is divided by the average number of the outstanding shares. The concept of use is also the same as the PER: the higher the value of PBV, the higher the price of the shares.

I personally prefer PER than PBV. And based on experience, the prediction of stock price changes using PER is slightly more accurate than using PBV. How can it be? It is because the value of net profit more closely reflects the actual performance of a company than the value of equity. The increase in equity can be obtained from additional paid-in capital, rights issue, or basically anything that is not derived from the performance of the company. While the net profit, almost certainly resulted from the company's performance.

However, the net profit of a company may not come from its operational performance, but rather the result of non-operating income, sale of assets, etc, so that the net profit may not show the actual performance of the company. That's why to become the good stock price analyst, you need an incredible precision.

Original article was written on May 31, 2010.