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If you’re new to stock trading, it can be tricky to decide what to invest in and how to determine its value. If you decide to invest in a major supermarket brand, how do you choose between similar companies like Kroger and Publix? Comparing the share prices of similar companies isn’t the same as calculating a stock’s real value.
4 ways to calculate the relative value of a stock
Many investors use ratios to decide if a stock offers a good relative value compared to its peers. Here are the four most basic ways to calculate a stock value.
1. Price-to-earnings ratio (P/E)
- What it is. Offers a snapshot of what you’ll pay for a company’s future earnings. It considers a company’s recent earnings per share (EPS) against the market price. You’ll often see the P/E with a number that is considered a multiple of the company’s earnings.
- Best time to use it. When you compare competing companies in the same industry. Investors say that a stock with a lower P/E is cheaper and probably under valued. For example, if Publix had a P/E of 25 and Kroger had a P/E of 12, Kroger would be considered the better value.
- Watch out for when a P/E ratio increases dramatically. This could mean investors overshot the expectations about the company’s actual earnings. Investors can get caught up in the market hype, anticipating significant growth, and push the stock price to the point it’s overvalued and due for a correction.
- How it’s calculated. Look for a company’s EPS figures on its website. Divide the current price share by the EPS to find the P/E. If the company has adjusted EPS figures, use those instead — any one-time major expense could affect the EPS.
Calculating the P/E
Let’s say company ABC has a current share price of $100 and an annual EPS of $10 as stated in its latest report. $100 divided by $10 is a P/E of 10. So, at the current price, you’re expecting to buy 10 years of earnings.
While there’s no definitive P/E that’s considered “good,” over the last century the S&P 500 has averaged a P/E of slightly more than 15, which is sometimes seen as a broad threshold for fair value.
2. Price/earnings-to-growth ratio (PEG)
- What it is. Considers a company’s earnings growth. Find the estimated earnings per share over the next year — included in the latest report.
- When to use it. To compare peer performance of companies in the same industry.
- What to watch out for. There’s no set PEG ratio that’s considered a definite “buy” signal, but some may treat a stock with a PEG ratio below 1 as undervalued.
- How it’s calculated. Use the P/E ratio and divide it by the growth in earnings per share (EPS).
Calculating the PEG
Company ABC has an estimated EPS of $11 over the next year as stated in its report. This is an increase of 10% over its current EPS of $10. Using the PEG formula of the P/E (10) divided by growth in EPS (10%), we have a PEG of 1.
3. Price-to-book ratio (P/B)
- What it is. A snapshot of the value of a company’s assets.
- When to use it. The closer the P/B ratio is to 1 (or below), the greater the perceived value of the stock. P/B is mostly used for mature companies with limited growth or companies whose goal is to accumulate assets rather than sell products.
- How it’s calculated. Divide the current share price by the stock’s book value. Then divide by the number of shares issued. The book value is worked out from the balance sheet as total assets minus total liabilities (or costs). The balance sheet with these figures can be found in the company’s latest earnings report on its website.
Calculating the P/B
Consider company XYZ. Its market price is currently $2, with 50 million shares issued. Total assets are $80 million and total liabilities are $20 million (this equals a book value of $60 million). Therefore, the P/B ratio is: $2 divided by ($60 million / 50 million) = 1.7
4. Free cash flow (FCF)
- What it is. A way for investors to see how much cash is left over after everything’s been paid. FCF skips much of the complexity of accounting and provides a clear view of how well the business is creating value.
- When to use it. Compare it as a raw number or as a ratio of FCF divided by total revenue to give you an idea of what percentage of every dollar of income turns into profit.
- How it’s calculated. FCF is the net cash from operating activities minus its capital expenditures.
Companies create value and make money in different ways, so valuation ratios often depend on the company and industry. For example, a bank is valued by how many assets it has and how well it grows those assets, so the price-to-book ratio is a good measure of value. Retailers, on the other hand, aren’t looking to accumulate assets — they’re trying to sell products and make a profit. So price-to-sales or price-to-earnings ratios would be better measures of value.
Other tips to help you value a company’s stock
In addition to the ratios above, which give you an idea of a stock’s relative value in line with similar companies, there are a couple more tips to help you figure out if a stock is priced fairly.
- Analyst recommendations. Major Wall Street banks like Goldman Sachs, JPMorgan Chase, Morgan Stanley and Citibank release their own reports analyzing companies. Within their analysis, they’ll include a buy or sell — or strong buy or sell. Or they can hold recommendation based on where they think the share price is heading.
- Analyst price targets. Within these reports, they’ll also include a price target for the company’s stock. This is the price they believe the stock will reach within the next 12 months — based on their analysis of the company and the market as a whole.
While relying on these analyst reports to determine intrinsic value or investment opportunities could be unwise, these reports may offer a more broad picture of a stock’s fundamentals.
Why should I value stocks before buying?
No one wants to pay more than they need to. The basic goal of investing in stocks is to buy when the price is low and sell when it’s high to make a profit.
Valuing a company’s shares against similar companies in the market is one of the easiest ways to do this. It can help you figure out if you’re potentially paying too much for a stock, if you’ve found a bargain buy or if you’re holding onto a potentially overvalued stock.
Technical vs. fundamental analysis
Because technical analysis is primarily concerned with stock price movements as shown in charts, it’s largely used for determining and following the underlying trend or market sentiment rather than measuring the value of a stock. If people are buying a stock, a technical analyst can assume that the company is creating value. If people are selling a stock, the assumption is that it isn’t worth the current price.
Fundamental analysis, on the other hand, aims to determine the intrinsic, or true, value and the relative value of the stock so that an investor or trader can anticipate whether the stock price will rise or fall to realign with that value. Fundamental analysts attempt to discover this intrinsic value based on the company’s financial statements, including its earnings and debt. Relative value is determined by comparing businesses against their peers, like comparing the price of Dollar General stock with Dollar Tree stock or comparing Bank of America stock with Citibank stock.
You don’t have to pick one or the other, though. Investors and traders can use fundamental analysis to compile a list of stocks that are likely to be undervalued and then use technical analysis to buy or sell those stocks when the trend changes.
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