Ask Colin

How is a share is actually priced? What does it mean if I read that xyz share is trading above its current valuation or that it is not cheap on a PE basis?

As you may realise, this is a big subject. There are many ways to value or price a share. Also it is inherently subjective, despite the apparent precision of the results from some experts. Valuing a share is similar in this respect to valuing a car or a house - ask six valuers and you are likely to get six answers. The share market deals with this at the institutional level by collecting all the analysts' valuations and publishing the range and the "consensus". You have to pay for this service, but journalists refer to it from time to time.

The really interesting thing to watch is takeovers. So-called "independent experts" reports are required, but it is interesting how the target company expert invariably puts a higher value on the company than the raiding company's expert does. This just shows how subjective the whole area of valuations is. A "can of worms" if you like.

One of the most bullet proof and simple methods of valuing a share is to use the PE ratio model. The idea is that when you buy a share, you are buying an entitlement to a share of future earnings in relation to the size of your holding. This is dealt with by expressing earnings on a per share basis (Total earnings divided by the number of shares issued).

The concept is that you will pay a certain multiple of the earnings. Thus, if you think a company is really good, you might pay 20 times its earnings per share. But if you think it is a laggard company, you might only pay 10 times its earnings.

What analysts do is look at the ratios for similar companies and say that represents some sort of consensus of value. If the company is selling for 25 times earnings when the average for its peers is 15 times earnings, it might be said to be expensive, unless you can see superior earnings growth for the company.

You have to bear in mind that PE ratios are historical; they are based on last year's earnings. However, they can be prospective, if calculated on estimated future year earnings. This is one way to handle the earnings growth question, but is only as good as the estimate the ratio is based on.

There are other valuation models including dividend yield models, discounted cash flow, the capital Asset Pricing Model (CAPM) and so on.

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