When entering the world of investing, you need to develop a specific set of skills to have the best chance of success. One of these skills is learning how to value a stock. Once you perfect this process, you’ll have a solid foundation to be able to better project future growth and determine whether the stock you are looking at is overvalued, undervalued, or priced appropriately. Though there are many ways to value stocks, some of the most popular include:
- P/E ratio.
- P/S ratio.
- Price-to-book ratio.
- Peer comparisons.
- Discount models.
- Conceptual methods.
Why Is it Important to Value Stocks?
When you buy a stock, you are buying a fraction of a company based on the number of shares you possess. You need to understand the stock’s intrinsic value, which is not actually its current market price. Many people invest based on the price of a stock, assuming that current price factors in all known information, which it rarely does.
When investors base a stock’s value on its current price, beating the market becomes just a matter of luck. Skilled investors, however, can sway the odds in their favor by valuing stock more appropriately. Active investors know that a stock’s value is different than its market price. They use a series of calculations, metrics, and qualitative analysis to determine the stock’s true intrinsic value and make an educated investment based on that value.
Using P/E Ratio to Find the Value of Stock
One of the cornerstones of valuing a stock is the standing price-to-earnings (P/E) ratio. To calculate this formula, divide the stock price by the earnings per share (EPS). The lower the P/E ratio, the more earning power investors will be buying with each share. This means the stock is likely to pay the investor back through earnings faster than a stock with a higher ratio.
For example, take a stock that has an EPS price of $4.10 and a current price per share of $73.75. To determine the P/E ratio, divide 73.75 by 4.10, which would give you a ratio of 17.98.
Other P/E ratios might differ from that calculation. This can occur when you calculate the P/E using generally accepted accounting principles (GAAP). GAAP is a universal set of standards companies use to report their earnings to the public. These principles were created to help prevent companies from hiding their true performance from investors. But in many cases, these calculations can be less than accurate.
A GAAP calculation might vary for a number of reasons, such as a company selling off an underperforming portion of its business. In this case, the proceeds from that sale might show in that quarter’s earnings but do not necessarily mean the company is doing well.
To help provide more transparency for investors, many companies now use non-GAAP earnings for reporting P/E. Because of the potential variations, it is important to take all the numbers into consideration before making a final investment decision.
What Is a Good P/E Ratio for Buying Stock?
There is no magic number that indicates when to buy a stock. Investors ultimately use P/E ratio in combination with several other factors to decide whether to buy. If you value stock with the P/E ratio, and the intrinsic value is higher than the current price, the margin of safety will be greater.
For a value investor, a lower P/E ratio might be more beneficial. Investors focused on growth, however, might not be interested in buying stock with low P/Es, as those stocks might be unlikely to have high growth rates. These investors will be looking for stocks with higher P/E ratios, believing the increased earnings growth is worth the elevated cost.
How Growth Investors Use Variations of the P/E Ratio
Often, growth investors will start with the P/E ratio for calculating other metrics used to value stocks, including the forward P/E and the price/earnings to growth (PEG) ratios. Forward P/E is an easy calculation to make once you have the P/E ratio. Using the same P/E equation, simply replace the EPS from the previous 12 months with the company’s projected EPA from the proceeding fiscal year. Then, divide the current stock price by the company’s expected future earnings for the upcoming year.
To calculate the PEG ratio, divide the company’s P/E ratio by its expected earnings growth. You can adjust the formula by using the growth earnings over different periods, but most investors will use projected five-year growth rates to calculate EPS. Although this can be a good metric to use, five years is a long time and includes multiple assumptions that might not come to fruition.
Other Metrics for Valuing Stock
While using the P/E ratio is one of the most common calculations for valuing stocks, many investors will use other metrics to estimate their possibility of success.
The P/S ratio, or price/sales ratio, is calculated by dividing the company’s market cap (the total value of the company’s outstanding share) by its annual revenue. This method relies on revenue over earnings, which is a good metric to use for companies that are just starting out and have not yet become profitable. You might also use it to value the stock of companies with inconsistent earnings growth.
As with P/E, there is no definitive calculation that will indicate the best time to buy and sell, and on its own, the P/S ratio does not offer much insight. But when combined with other metrics, it can help you come up with a better plan and aid your decision-making process.
Another type of metric that can help you make a decision is the price-to-book ratio. To determine book value, calculate the company’s assets and subtract its liabilities, which you can find on a company’s balance sheet. Then calculate the book value per share by dividing the book value by the number of shares owned for the company. To get the price-to-book ratio, divide the share price by the book value per share.
While this metric can be helpful, investors don’t often use it for valuing stock in businesses such as software tech companies. If you are looking to invest in a company that reports a number of assets, however, it can be a valuable metric to incorporate.
Peer comparisons are commonly used metrics for valuing a stock. By calculating the ratios of similar companies, you can see how one stacks up against its competition. In truth, a company’s value is relative to that of other companies in similar scenarios. One thing to watch for is whether a company is growing its earnings faster than its peer companies. If this is the case, you should value it higher than those companies.
Investors often use discount models to value stocks in combination with others. This involves valuing a company’s present value by calculating all of its potential future cash flows. The only drawback to this method is it can use a number of calculations and is based on multiple assumptions, some of which might never materialize. To determine this metric, project all future cash flows and then discount them to come up with a present value.
This method is a particularly popular option for valuing dividend stocks. To calculate the true price of the stock, divide the annual dividends per share the next year by the discount rate minus the growth rate. The discount rate is the rate of return you desire to make on the investment.
Some finance gurus favor a more conceptualized model to valuing stock. This is an abstract way to value stock based on a number of assumptions. Basically, you create the narrative you expect from the company using calculations such as discounted cash flows. You will value each possible scenario and then discount all the less-likely-to-occur scenarios before adding them together. This involves a lot of estimating to try to determine all the possible narratives.
Learning how to properly value stock is a vital component of successful investing. By knowing a stock’s intrinsic value, you will be better able to determine whether to buy or sell. Do you want to take your first steps toward becoming a more successful investor? Sign up for one of our seminars, or download our free e-book today.