Identifying Undervalued Stocks: A Case-study of Saudi Stock Market

* Rao, D.N. Do you know the story of a person looking under a street lamp for a coin that he lost? A passerby offered to help and asked where he lost it. The answer he received was that it was further up the street but there was no light there to search properly! It is much the same in the stock market. People look for value in terms of trying to answer questions such as whether or not a particular stock is 30 percent undervalued or 20 percent overvalued. Then they wonder why their performance is mediocre. The problem is that they are confused with various static definitions of value with value in terms of performance. No wonder finding undervalued stocks is a mystery for most people.

I. Introduction In our daily life, when we want to buy a TV, a personal computer or a refrigerator or any other durable product, we look for quality, long life, fair price and brand name. It is much the same with investing in equities but most of the Saudi investors ignored this basic principle of investment. This is evident from the volatility of the Saudi stock market during the past 12 months which witnessed high speculation, lack of direction, and overall confusion that led to the rise and fall of the Saudi stock market index (TASI) beyond justifiable levels. The aim of investing in equity is to get a healthy return by holding the stock for a longer duration. The return on a stock (dividends and price appreciation over the holding period) is tied to the future performance of the company. Further, an investor should know why he is buying or selling a particular stock and the timing of his buy- and- sell decisions. In other words, investors who are directly investing in the stock market should have the knowledge and skills of stock valuation that is whether a particular stock is undervalued, overvalued or fair priced. Investors must bear in mind that a true undervalued stock is first of all a quality company and secondly it is selling at a price that you can be confident of future appreciation to yield a healthy return (of course, with a margin of safety). It starts by identifying good companies in terms of management performance, strong and consistent growth and optimum debt equity level. --------------------------------------------------------------------------------------------------------------------------------* The author is currently the Head of Equity & Economic Research Group at The Consulting Center for Finance & Investment, Riyadh, Kingdom of Saudi Arabia.

The value-oriented approach is based on long-term investing and the objective is to identify those stocks that are undervalued relative to the market or their industry group with the assumption that the market will eventually recognize the value of the stock, and the price will rise. The approach involves computing a number of valuation measures of a company and comparing them with that of industry and/or stock market norms.
The purpose of this article is to illustrate a simple and easy method to identify undervalued stocks in Saudi Stock Market to enable the investors for making well informed and conscious investment decisions. The article briefly reviews commonly used stock valuation measures prescribed in finance literature and illustrates the application of PEG ratio as one of the better valuation measures to identify undervalued stocks in the context of Saudi stock market.

II. Valuation measures The following describes the commonly used valuation measures and useful tips for calculating and using them for equity investment decisions.
Price-to-Earnings Ratio (P/E)

The Price-to-Earnings ratio is the most commonly used valuation measure for equity investment and this ratio indicates how much investors are willing to pay today for SR1 of the companys future earnings. This ratio is determined by dividing the price of a stock by the companys net earnings per share. It is important to realize that different companies tend to sell at different P/E ratios depending upon their future growth prospects. Usually, a low P/E ratio of a company as compared to that of the industry/sector and the stock market indicates a stock to be fairly valued or undervalued and a high P/E ratio indicates a stock to be overvalued. However, this may not always be true and it is also important to evaluate the balance sheet, quality of earnings, growth prospects etc. before investing. Stocks with low P/E ratio are good starting point for value-oriented investors. This method requires calculation P/E ratio of the stock, sector and market indices. Buying stocks, whose P/E ratio is less than that of sector and market is considered safe provided the fundamentals of the company are sound. In such a situation, the stock is considered to have good potential for price appreciation due to the high probability of P/E of the stock approaching or exceeding P/E of the sector and the market.

To determine if a company is selling below normal P/E, compare the P/E of a particular stock to that stocks historical P/E ratio, P/E for the industry (sector), and the P/E of the market. If you determine that the company is selling at a relatively low P/E, try to determine the cause. Are the companys earnings below normal? Is there a problem with the company, or is this merely an undervalued situation whose potential is yet to be discovered?
Price-to-Book Value Ratio

Book value is the value of a companys total assets minus total liabilities. In the case of price-tobook value ratio, it is important to keep in mind that there are differences among industry groups. For example, a steel company would tend to trade at a lower price-to-book value since such a company would have a much greater level of physical assets than would a computer software company whose main assets might be copyrights on software programs and the programming knowledge of its employees.

To calculate price-to-book ratio, take the assets of a company and subtract the liabilities, intangible assets, and uncapitalised lease obligations. Divide this value by the number of shares outstanding. As with the P/E, compare this ratio to the market, the industry group, and historic norms to determine if the companys current price implies a relative undervaluation.
Dividend Yield

A value investor would try to compare a companys dividend yield to the market, its industry group, and the historic norm for the company, to see if the stock is selling at a higher than normal yield. If so, they would try to determine why this is the case. It may be that the market is anticipating a dividend reduction. To calculate dividend yield, divide the annual dividend the company pays its common stockholders by the price of the stock. Keep in mind that dividends also vary among industries. Utility stocks for example, tend to trade at a higher yield than do food companies.

Price-to-Cash Flow Ratio This measure is popular among value investors because earnings are more easily affected than cash flows. As with price-to-book value ratio, look to identify those companies trading at low price-to-cash flow ratio. Keep in mind that cash flow ratios can vary from industry to industry.

Price Earning Growth Ratio

The problem with P/E ratio is that it is a meaningless number, by itself. Is P/E of 5 good or bad? Or should it be 10? Or possibly say 25? Mathematically speaking, the lower P/E of a stock it's

considered better than a higher P/E stock. But is it really so? The following two questions probably may help us to resolve the paradigm: Question 1: Why do people invest in stocks? Question 2: But, why should the price of a stock should go up? The most likely answers to the above questions are given below: Answer 1: People invest in stocks because when the price goes up, they can sell the stock and make profit. Answer 2: the price would go up if the company makes higher profits i.e. higher earnings per share (there are, of course, many other reasons for share prices to go up, but from the fundamental perspective, the price of a share is ultimately a reflection of it's profits). In other words, it is the growth in the earnings, which gets reflected in the share price. And since we are buying a share in anticipation that its price will go up in future, we must look at the expected growth rate of its earnings, especially over the next 2 to 3 years. Hence, comparing the two i.e. the P/E ratio and the EPS growth of a company gives a more meaningful picture. The Price Earning Growth Ratio is defined as: PEG ratio = PE ratio / EPS growth rate. The PEG ratio is interpreted as given below: PEG ratio=1: this means that the stock price is fully reflecting the company's future growth potential i.e. the stock at today's price is fairly valued. PEG ratio>1: this indicates that the share price is higher than the expected growth in the company's profits i.e. the stock is possibly overvalued. PEG ratio<1: this indicates that the stock price is lower than the expected growth in the company's profits i.e. the share is possibly undervalued.
Therefore, the PEG ratio indicates something more about the future potential of the company. It also gives us an idea whether the high PE is a superficial number or is supported by future growth prospects.

Illustration: An information technology company whose P/E ratio is 30 and expected EPS growth rate of 40%. And then, we have a banking stock, with P/E ratio of 12 and EPS growth rate of 8%.

At first glance, by looking at the P/E ratio, the banking stock looks cheaper and more attractive. On the contrary, a comparison of PEG ratio of the two stocks gives a different picture: IT company PEG = 30/40 = 0.75
Bank PEG = 12/8 = 1.50

Going by the definition of PEG ratio, we find that the IT companys stock 'is undervalued considering its future growth prospects. Therefore, its share price is likely to appreciate more than the bank stock. As always, there is a word of caution:- like any other financial number, the PEG ratio is not a law, but a very useful indicator whether a share price is undervalued or overvalued as we are only estimating the EPS growth.

III. Applying value measures to identify undervalued stocks in Saudi Stock Market Out of the 5 valuation measures suggested above, PEG ratio has been chosen to identify undervalued stocks (in the Saudi Stock Market) as it indicates about the future potential of the company more than other valuation measures described above. PEG ratio, in effect, indicates how much (at what price) the investors are willing to pay per unit change in EPS and hence it is considered superior to other stock valuation measures. The PEG ratio for 76 of the 81 stocks spread across 8 sectors was computed as a ratio of P/E (as on 31st August 2006) and Estimated growth in Earning Per Share for the next 2-3 years. The following method was adopted for estimating growth in EPS for the next 2 to 3 years: Average (Geometric Mean) growth in EPS was computed for each of the 81 stocks based on EPS of the stocks for the years 2000 to 2006 (data for six years). Geometric Mean, rather than Arithmetic Mean provides true return of a stock, as the earnings of stocks are susceptible to large-scale fluctuations. Hence, Geometric Mean growth in EPS over the period 2000-06 is taken as a surrogate measure of the estimated growth in EPS for the next 2 to 3 years, though past performance does not guarantee future performance. However, past data over a 6-year period sufficiently covers a full economic cycle such as boom and recession and facilitates a good estimation of the growth rate for the next 2 to 3 years.

Valuation of the Banking sector stocks is presented below:

Table 1: Valuation of Banking sector stocks Banking sector P/E EPS Growth% 13.37 68.12 17.47 5.57 22.13 16.64 22.04 5.97 8.19 NC** PEG

Riyad Bank 15.28 1.14 Bank Al-Jazira 12.65 0.19* Saudi Investment Bank 9.82 0.56* Saudi Hollandi Bank 25.53 4.58 Banque Saudi Fransi 14.22 0.64* The Saudi British Bank 17.36 1.04 Arab National Bank 13.47 0.61* SAMBA Financial Group 15.69 2.63 Al Rajhi Bank 29.11 3.55 Bank Al Bilad 78.50 NC Banking sector 18.50 Saudi Stock Market 22.29 (Source: compiled from CCFI Database) * Undervalued stocks; **NC: Not computed since only one year of operations.

In Table 1, it may be observed that 4 stocks (marked *) have PEG ratio of less than 1 and these stocks are considered as undervalued. Further, the P/E ratios of these the stocks are less than that of Banking sector and the Saudi stock market, which confirms that these stocks are undervalued. PEG ratio of Saudi British Bank is marginally above 1 and hence may be considered as fairly priced. The other 4 stocks (Riyad Bank, Saudi Hollandi Bank, SAMBA Financial Group and Al Rajhi Bank) have PEG ratio greater than 1 and are considered as overvalued stocks though their P/E ratio may be either more or less than that of Banking sector and Stock market.

Valuation of the Industrial sector stocks is presented below:

Table 2: Valuation of Industrial sector stocks Industrial sector Saudi Basic Industries Corp.(SABIC) Saudi Arabia Fertilizers Co. (SAFCO) Suadi Arabian Refineries Co. (SARCO) Saudi Ceramics Co. SAVOLA Group National Industrialization (NIC)
Saudi Pharmacuetical Indus. & Med. Appliances Corp. (SPIMACO)

P/E 19.86 26.31 983.61 33.97 52.16 21.95

67.92

EPS Growth 28.62 26.53 -30.43 -335.75 29.62 33.15

9.44

PEG 0.69* 0.99* -32.32 -0.10 1.76 0.66* 7.19 -23.45 3.61 -0.40 -0.43 -4.29 0.45* -0.11 0.22* -2.02 5.18 6.64 -3.82 0.42 0.93* 10.88 -1.49 1.05 1.26 0.31* 0.67* -1.44 NC NC

National Gas & Industrialization Co. (GASCO) National Gypsum Co. Food Products Co. Saudi Cables Co. Saudi Advanced Industries Co. Saudi Industries Development Co. Al-Ahsa Development Co. The National Co. for Glass Ids. (Zujaj) Saudi Arabian Amiantit Co. Alujain Corporation Filling & Packing Material Mfg. Co. (FIPCO) Saudi Industrial Services Co. Arabian Pipes Co. Nama Chemical Co. National Metal manufacturing Saudi Chemical Co. Zamil Industrial Investment Co. Saudi Industrial Investment Group Sahara Petrochemical Co. Saudia Dairy & Foodstuff Co. Almarai Company Limited Yanbu National Petrochemical Company Saudi Paper Manufacturing Company Industrial Sector Saudi Stock Market (Source: compiled from CCFI Database) NA: Not available; NC: Not computed; * Undervalued stocks

44.09 30.32 26.45 65.58 646.99 -147.30 31.67 19.43 375.52 -1396.32 93.19 1067.29 43.00 375.85 866.17 30.69 28.72 30.56 34.08 -125.18 31.31 NA 53.01 25.40 22.29

-1.88 8.40 -66.46 -152.75 -150.70 -330.13 -290.70 87.79 -186.11 -269.77 14.04 -279.05 102.23 403.97 79.61 -20.63 27.43 24.21 109.77 -185.48 -21.79 NC NC

In Table 2, it may be observed that the PEG ratio of 8 stocks (marked *) is less than 1 and hence these stocks are considered as undervalued. The P/E ratio of these stocks is either more or less than that of the sector and market. The PEG ratio of Zamil Industrial Investment Co. is marginally above 1 and hence the stock is considered as fair priced. The PEG ratio of the 8 stocks is more than 1 and hence they are considered as overvalued stocks. Eleven stocks have negative PEG ratio either due to negative P/E ratios or negative earnings growth rate and also 10 of these stocks have P/E ratio more than that of the Industry sector and Saudi stock market and are considered as overvalued stocks.

Valuation of the Cement sector stocks is presented below:

Table 3: Valuation of Cement sector stocks Cement sector P/E EPS Growth% PEG

Arabian Cement Company Ltd. Yamamah Saudi Cement Company Ltd. Saudi Cement Company Co. The Qassim Cement Co. Southern Province Cement Co. Yanbu Cement Co. Eastern Province Cement Co. Tabuk Cement Co.
Cement Sector Saudi Stock Market (Source: compiled from CCFI Database)

19.12 22.84 16.97 30.39 20.58 18.45 19.29 20.34

20.58 22.29

30.80 15.29 22.46 9.71 20.03 23.52 15.08 46.66

0.62* 1.49 0.76* 3.13 1.03 0.78* 1.28 0.44*

In Table 3, it may be observed that the PEG ratio of 4 stocks (marked *) is less than 1 and hence these stocks are considered as undervalued. The P/E ratio of these stocks is less than that of the sector and market. The PEG ratio of Southern Province Cement Company is marginally above 1 and is considered as fairly priced. The PEG ratio of the remaining 3 stocks is more than 1 and hence they are considered as overvalued stocks. Valuation of the Service sector stocks is presented below:
Table 4: Valuation of Service sector stocks Service sector P/E EPS Growth% PEG

Saudi Hotels & Resort Areas Co. Saudi Real Estate Co. (Akkariyah) The National Shipping Co. of Saudi Arabia Saudi Public Transport Co. (SAPTCO) Saudi Automotive Services Co. (SASCO) Al Mawashi Al Mukairish United Co. Tihama Advt. Pub. Relations Co. Aseer Trading, Tourism & Manufacturing Co. Taibah Investment & Real Estate Co. Makkah Constr. & Development Co. Saudi Land Transport Co.(Mubarrad) Al Baha for Development Co. Saudi Industrial Exports Co. Arriyadh Development Co. (Construction) National Agr. Marketing Co. (Themar) Tourism Enterprises Co. (Shams) AHMED H.FITAIHI COMPANY Jarir Marketing Company Aldrees Petroleum & Transport Co. Saudi Research and Marketing Group
Service Sector Saudi Stock Market (Source: compiled from CCFI Database)

114.64 79.97 20.18 8.84 50.56 -61.39 162.61 41.00 85.16 75.29 156.73 -733.60 48.24 77.45 -74.48 -163.93 156.76 22.13 68.27 22.55
41.30 22.29

22.72 18.71 -276.05 34.02 113.92 -14.07 -100 79.51 40.14 -7.1 -172.88 -3.3 62.35 6.86 1.38 -28.31 7.39 15.32 NC NC

5.05 4.27 -0.07 0.26* 0.44* 4.36 -1.63 0.52* 2.12 -10.60 -0.91 222.30 0.77* 11.29 -53.97 5.79 21.21 1.44
NC NC

In Table 4, it may be observed that the PEG ratio of 4 stocks (marked *) is less than 1 and hence these stocks are considered as undervalued. The P/E ratio of these stocks when compared to that of Service sector and Saudi stock market is either less or more giving mixed results. The PEG ratio of 9 stocks is more than 1 and hence they are considered as overvalued stocks. Five
stocks have negative PEG ratio either due to negative P/E ratios or negative earnings growth rate and also these stocks have P/E ratio either more or less than that of the Service sector and Saudi stock market giving mixed results and are considered as overvalued stocks.

Valuation of the Agriculture sector stocks is presented below:

Table 5: Valuation of Agriculture sector stocks Agriculture sector P/E EPS Growth PEG

National Agricultural Development (NADEC) Qasim Agriculture Co. (GACO) Hail Agriculture Development Co. (HADCO) Tabuk Agriculture Development Co. (TADCO) Saudi Fisheries Co. Ash Sharqiyah Agriculture Development Co. Al Jouf Agricultural Development Company Bishah Development Company Gazan Development Company
Agriculture Sector Saudi Stock Market (Source: compiled from CCFI Database)

40.23 -91.63 319.57 57.43 -252.92 -2026.92 77.50 1732.76 15.30 70.25
22.29

58.76 118.87 -301.48 41.77 -229.73 332.04 13.1 46.63 -464.87

0.68* -0.77 -1.06 1.37 1.10 -6.10 5.92 37.16 -0.03

In Table 5, it may be observed that the PEG ratio of only one stock (marked *) is less than 1 and hence the stock is considered as undervalued. The P/E ratio of this stock when compared to that of Agriculture sector and Saudi stock market is either less or more giving mixed results. The PEG ratio of 4 stocks is more than 1 and hence they are considered as overvalued stocks. Four stocks
have negative PEG ratio either due to negative P/E ratios or negative earnings growth rate and also these stocks have P/E ratio either more or less than that of the Agriculture sector and Saudi stock market giving mixed results and are considered as overvalued stocks.

Valuation of the Electricity sector stock is presented below:

Table 6: Valuation of Electricity sector stock Electricity sector P/E EPS Growth PEG

Saudi Electricity Company Electricity sector Saudi Stock Market

135.39 135.39 22.29

17.62

7.68

(Source: compiled from CCFI Database)

In Table 6, it may be observed that the sector consists of only one stock and the PEG ratio of the stock is more than and hence the stock is considered as overvalued. Valuation of the Telecom sector stocks is presented below:
Table 7: Valuation of Telecom sector stocks Telecom sector P/E EPS Growth PEG

Saudi Telecommunications Company Etihad Etisalat Telecom sector Saudi Stock Market
(Source: compiled from CCFI Database)

14.90 127.35 17.38 22.29

20.30 -10.40

0.73* -12.25

In Table 7, it may be observed that the sector consists of two stocks only. PEG ratio of Saudi Telecommunications Company (STC) is less than 1 and hence the stock is considered as undervalued. The P/E ratio of STC stock when compared to that of Telecom sector and Saudi stock market is less confirming under valuation of the stock. Etisalat is a new company and has only been in operation for one full financial year. The EPS growth rate and PEG ratio of Etisalat computed are observed to be negative and the estimates may not be reliable since they are based on one-year data. To classify the Etisalat stock in the absence of a valid PEG ratio, it is advisable to compare the P/E ratio of the stock with that of Telecom sector and the Saudi stock market. As per this criterion, Etisalat stock may be considered as overvalued. Valuation of the insurance sector stock is presented below:
Table 8: Valuation of Insurance sector stock Insurance sector P/E EPS Growth PEG

National Company for Cooperative Insurance Insurance sector Saudi Stock Market
(Source: compiled from CCFI Database)

15.11 15.11 22.29

-8.15

-1.85

In Table 8, it may be observed that the sector consists of only one stock and the EPS growth rate PEG ratio of the stock is negative due to negative EPS growth and the company was in operation for only two financial years and hence the estimates computed are not much reliable and hence the PEG ratio may not be relied upon for stock valuation. in the absence of a valid PEG ratio, the alternative is to compare stock P/E with that of sector P/E and market P/E. However, the sector consists of only one stock and hence it is advisable to compare the P/E ratio of the stock with that of the market. As per this criterion, NCCI stock may be considered undervalued.

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Summary of stock valuation sector wise is presented below: Table 9: Summary of stock valuation sector wise
Sector Banking Under Valued 4 Fair Priced 1 Over Valued 4 Total No. of stocks valued 9 % of under valued stocks 44.44 % of over valued stocks 44.44

Industrial Cement Service Agriculture Electricity Telecom Insurance IV. Conclusion

8 4 4 1 0 1 1

1 1 0 0 0 0 0

19 3 14 8 1 1 0

28 8 18 9 1 2 1

28.57 50.00 22.22 11.11 0.00 50.00 100.00

67.86 37.50 77.77 88.88 100% 50.00 0.00

Furthermore, the analysis in the context of Saudi stock market led to the observation that P/E ratio alone was not sufficient for clear identification of undervalued and overvalued stocks as there were ambiguous situations (such as, stock P/E ratio being lower than market P/E ratio but higher than the sector P/E ratio and also there were situations of stock P/E ratio being higher than market P/E ratio but lower than the sector P/E ratio etc.) which led to more confusion with regard to stock valuation. From the analysis, it was observed that P/E ratio being a static ratio (that is, it is like a snap shot at a particular point of time like at the end of a quarter or a year etc) lacks the predictive and discriminatory power of PEG ratio which is dynamic as it takes into consideration the growth rate of future earnings which is consistent with the one of the most important determinants of a stock price. Disregarding Electricity, Insurance and Telecom sectors, which have one or two players, Agriculture sector has the maximum percentage of over valued stocks (88.88%), followed by Service sector (77.77%), Industrial sector (67.86%) and Banking sector (44.44%). Cement sector has the lowest percentage of overvalued stocks (37.50%).

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