Valuating a stock using quantitative analysis

What is quantitative stock analysis? It's a technique that involves looking through the numbers of a company from their financial statements and using that information to generate a set of financial metrics. Why would you use quantitative methods for investment analysis? For starters, quantitative analysis is very effective as numbers don't lie or display any biases. It's straightforward too - anyone can interpret those metrics and it's less susceptible to error. Quantitative analysis isn't difficult to carry out as financial data is readily available, so this technique should provide a good fit even if you're relatively new to investing.

Since this financial data is readily available online to the general public, quantitative analysis has become a widely used technique among analysts and investors.

Let's do a deeper dive here and explore 4 popular metrics you can use with quantitative analysis:

  • Profit-to-earnings ratio (P/E ratio)
  • Peer-to-peer comparison of companies
  • Revenue growth
  • Gross profit margins

P/E ratio

  • A profit-to-earnings ratio, or P/E ratio, is basically the amount an investor is willing to pay for a company's share relative to its earnings. For example, a company with a P/E ratio of 7 means that investors are willing to pay SGD7 for every dollar of its earnings.
  • This is the basic formula used to calculate a company's P/E ratio:
    P/E ratio = Current share price ÷ earnings per share
  • A high P/E ratio may suggest the company has high growth potential, whereas a low ratio would indicate that the growth of this company is expected to be slow. But of course, this isn't a hard and fast rule.
  • It's always a good idea to compare the P/E ratio of a company to other companies in the same sector if you're considering purchasing the counter. The stock of a company with a P/E ratio above the industry average might be considered expensive compared to the ones with lower P/E ratios.
  • In short, a high P/E ratio could mean that a company's stock price is high compared to its earnings, meaning it is possibly overvalued. On the other hand, a low P/E ratio may suggest the company's current stock price is low relative to its earnings.

Peer-to-peer comparison of companies

  • Peer-to-peer comparison of companies enables you to compare different companies in the same industry that are of a similar size, in order to derive a fair value for them.
  • For instance, if you wish to see how Singtel stock performs, it's best to compare it with similar competitors in the same industry, such as StarHub and M1.
  • To perform a peer-to-peer comparison, you can choose several relevant valuation metrics, such as, the P/E ratio, earnings before interest, taxes, and amortization (EBITA), and the price-to-sales ratio (P/S ratio) or other ratios to see how they've performed against each other. Be sure to record your observations of which company has a better operational performance and greater potential for future growth, so you can factor that into your quantitative analysis for a more holistic view.

Revenue growth

  • Revenue is perhaps the most important number in a company’s financial accounts. When analysing a company’s revenue growth (or decline), you'd need to compare the previous period's revenue with the current period's revenue. Each time period you're measuring should be of equal length so your analysis is accurate. Here's the formula to calculate a company's revenue growth, expressed in percentage form:
    Revenue growth = ((Revenue this period - revenue last period) ÷ revenue last period) x 100%
  • So, what would be considered a percentage indicating good revenue growth? How much growth is considered ideal? This will depend on the company, the industry it is in and other economic factors. However, in general, a yearly growth rate of 10% sustained over a number of years is considered very good. According to research* by Bain & Company, only about 10% of global companies can sustain an annual growth rate in revenue and earnings of at least 5.5% over a period of 10 years, while also earning back their cost of capital.

* Source: https://media.bain.com/Images/BAIN_BRIEF_The_strategic_principles_of_repeatability.pdf

Gross profit margin

  • A company's gross profit margin is a ratio that shows the percentage of its gross profit in comparison to its sales. The gross profit margin is essentially the ratio of profit left from sales after deducting the cost of sales (COGS). It's calculated using this formula:
    Gross profit margin = (Net Sales - COGS) / net sales
  • Generally, the higher a company's gross profit margin ratio, the better it's performing. A higher ratio indicates the company is managing its COGS well and accordingly, has more to cover for its operating, financing, and other costs.
  • The gross profit margin will show you a company's cost efficiency and help you track its performance across a period of time. It also helps you assess the overall financial health of a company and helps make peer-to-peer comparisons convenient to carry out.

So why choose quantitative analysis?

  • While there are other techniques to analyse a stock, such as fundamental and technical analysis, quantitative analysis has proven to be very popular as the historical and current financial data of most companies is readily and publicly available. Utilising quantitative methods for investment analysis is also possible with just a little analytical or research practice, and even beginner investors can use this technique effectively and conveniently to valuate stocks and make sound investment decisions. Furthermore, this analysis technique can be used across a wide range of sectors since you'll be able to obtain reliable data continuous over your desired periods of time or investment tenors.

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