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FOOL SCHOOL
Spotting Value In Shares

February 15, 2002

The theoretical value of any company is based upon its future earnings. As an investor, it's your job to evaluate whether the company's current share price adequately reflects the company's long-term earnings potential. The trick to successful investing is buying companies that have much greater earnings potential than their valuation suggests. There are all sorts of ways to declare a share is "undervalued". For more details, see the articles entitled 'Valuation' that we ran in this series of articles in January.

Perhaps the most common measure to judge "good value" is by the prospective price to earnings (P/E) ratio. Calculated by dividing the company's share price by its expected earnings per share (EPS), the prospective P/E ratio gives a quick fix on how highly the stock market values the company's near-term profits.

At the time of writing, the average UK company's prospective P/E is around 20. Companies sporting a P/E below this level tend to have low growth prospects, while those exhibiting a P/E above this level usually have above-average prospects. Companies that have low P/Es but possess above-average earnings growth potential are candidates for a "good value" label.

However, a company with a P/E of 100 may be good value if you think its profits will grow exponentially over the next few years.  Few companies will be able to produce this sort of growth though. Similarly, a P/E of 5 may not represent good value if the company is in deep financial trouble. It may indicate that investors expect its profits to decline or even disappear altogether. In short, investors have to weigh up the company's immediate valuation with its long-term growth prospects.

But whatever you do, do pay attention to the valuation aspect of any share purchase. As most investors will have seen with the dotcom bubble and its aftermath, paying far too much for any company's growth prospects can seriously damage your portfolio.