How Analysts Value Companies and Why Diversification Matters…
Investment analysts use a variety of tools to assess companies. While individual stock analysis can be powerful, taking the diversification route often proves to be the smarter, more stable approach.
When analysts describe markets or specific companies as “overvalued” or “undervalued,” rest assured that a significant amount of numerical analysis lies behind those judgments.
But how do analysts actually reach these conclusions? Is there a definitive formula for identifying a bargain or avoiding an overpriced stock?
The answer is nuanced—it depends on many variables.
Understanding Analyst Valuation Methods
A key rule of investing is to do your homework before committing any money.
If you're considering individual stocks, part of your research may involve reading reports by investment analysts. These typically include insights into a company’s operations, past performance, and growth potential. Based on this, analysts often issue ratings like “buy,” “hold,” or “sell.”
To estimate a stock’s “fair value,” analysts draw from a variety of quantitative tools. Common methods include:
1. Price-to-Earnings (P/E) Ratio
Calculated by dividing a company’s current share price by its earnings per share (EPS), the P/E ratio shows what investors are willing to pay for a company’s past earnings. A high P/E might indicate strong growth expectations, while a low P/E could suggest the stock is undervalued—or underperforming.
2. PEG Ratio (Price/Earnings to Growth)
The PEG ratio adjusts the P/E by factoring in expected earnings growth. It’s computed by dividing the P/E ratio by the company’s anticipated growth rate. A lower PEG can signal a potentially undervalued growth opportunity.
3. Return on Equity (ROE)
ROE measures how efficiently a company generates profit from shareholder equity, calculated by dividing net income by net assets. Higher ROE typically points to effective management and strong financial health.
4. Free Cash Flow (FCF)
Free cash flow is the cash left after covering operating and capital expenses. Healthy FCF allows for reinvestment or shareholder returns and is often used in forecasting future growth.
The Case for Diversification
Despite access to the same data, analysts often arrive at different conclusions—because subjective judgment plays a big role alongside the numbers.
To sidestep this complexity, investors might opt for diversification instead of betting on individual stocks.
By investing in managed funds or exchange-traded funds (ETFs), especially broad-based index funds, you gain exposure to hundreds or even thousands of companies. These funds typically mirror the market by weighting companies according to their size.
This strategy—pioneered by Vanguard founder John C. Bogle—lets you invest in a broad swath of the market, capturing the collective strength of top-performing companies.
Over time, broad diversification has proven effective in reducing risk and delivering consistent returns. Rather than searching for a few winning stocks, spreading your investment across the entire market can offer a more reliable path to long-term growth.
Rick Maggi, Financial Advisor Perth, Westmount Financial
Disclaimer
This document has been carefully prepared by Westmount Securities Pty Ltd (ABN 42 090 595 289, AFSL 225715) for general information purposes only. However, neither Westmount Securities Pty Ltd nor any of its affiliates guarantee the accuracy or completeness of any statements contained herein, including any forecasts. It is important to note that past performance is not a reliable indicator of future outcomes. This material does not consider the specific objectives, financial circumstances, or needs of any particular investor. Therefore, before making any investment decisions, investors should assess the relevance of this information to their individual situation and consult professional advice, taking into account their unique objectives, financial position, and needs.