Want to master stock valuation like a pro? You’re in the right place! This easy-to-follow guide is perfect for investors who want to learn the crucial skill of determining a company’s stock price.
Knowing how to evaluate if a stock is over or undervalued can make all the difference in your investing journey. In this article, you’ll discover all the key tips and techniques to accurately value a stock.
Ready to become a smart investor? Let’s dive in!
Table of Contents
What is a Stock?
Stocks, often referred to as shares or equity, let you own a piece of a publicly traded company. When a company decides to go public, it offers shares for sale, allowing anyone to become a part-owner.
Each share represents a tiny slice of the company, with the stock’s value tied to the company’s financial well-being and performance. As a stockholder, you get a say in major company decisions and may even receive a cut of the profits through dividends.
Why Assign Values to Stocks?
Investing in the stock market requires an understanding of the true value of stocks, which is not always the same as their market price. The intrinsic value of a stock, rooted in business fundamentals, represents its true worth, while the market price is its current selling price. Valuing stocks helps investors determine whether to buy or sell.
Active investors, aiming to outperform the market, calculate metrics to estimate a stock’s intrinsic value. By comparing this value to the market price, they can identify undervalued or overvalued stocks.
Passive investors, who believe in the efficient market hypothesis, assume that market prices accurately reflect intrinsic value. Consequently, they typically invest in index funds or ETFs instead of attempting to outsmart the market.
Regardless of the investing approach, valuing stocks is essential for making informed decisions. Various metrics, such as earnings per share, price-to-earnings ratios, and dividend yields, can be used to estimate a stock’s intrinsic value. This understanding helps investors identify promising investment opportunities.
Stock Valuation: P/E Ratio as the Cornerstone Metric
If you’re interested in learning how to determine the value of a stock, one widely-used method is the price-to-earnings (P/E) ratio. This valuable metric can give you a sense of the return you can expect on your investment.
To compute the P/E ratio, simply divide the company’s current stock price by its latest earnings per share (EPS). A low P/E ratio is generally more attractive to investors, as it suggests you’re getting more value for your money.
Take Walmart (NYSE:WMT) as an example. The company’s 2021 fiscal year ended on January 31, 2021, with reported diluted earnings per share of $4.75. As of today, the stock price is $139.78.
To find Walmart’s P/E ratio, you need to divide the stock price ($139.78) by the EPS ($4.75). This calculation results in a P/E ratio of 29.43. And there you have it—a simple and efficient method for evaluating a stock’s value using the P/E ratio.
Understanding the P/E ratio can help you make informed decisions when investing in stocks. However, it’s essential to consider other factors, such as a company’s growth prospects, financial health, and market conditions, as well. The P/E ratio is just one of many tools that can assist you in building a well-rounded investment strategy.
GAAP vs. Adjusted Earnings for P/E Ratio Calculation
Ever been baffled by the term GAAP earnings? Don’t fret; it’s simply an abbreviation for Generally Accepted Accounting Principles. Essentially, a company’s GAAP earnings are the profits they report, adhering to these widely-accepted principles. But what’s the significance of this?
The thing with GAAP earnings is that they don’t factor in unique or unusual events that could impact a company’s profits, such as buying a new business division or receiving tax breaks. This can lead to considerable variations in the earnings reported.
Consequently, some investors prefer to use an adjusted earnings figure when calculating a company’s P/E (Price-to-Earnings) ratio, as it accounts for the financial consequences of these uncommon occurrences.
Take Walmart as an example. Their P/E ratio of 29.43 was computed using unadjusted (GAAP) earnings of $4.75. However, in their most recent earnings report, they mentioned an adjusted EPS (Earnings Per Share) of $5.48 for the same timeframe. This adjusted EPS figure takes into account losses connected to their Japan and U.K. operations, gains on their equity investments, and the impact of restructuring fees.
By using this adjusted EPS value, we can determine Walmart’s P/E ratio to be 25.50, which offers a more precise reflection of their earnings.
What Is a Good P/E Ratio for a Stock?
When exploring the price-to-earnings (P/E) ratio in the context of stock investments, it’s important to remember that what one investor finds appealing may not be the same for another.
Investors’ objectives can vary significantly, influencing their perspective on P/E ratios. Some investors may prioritize value, while others focus on growth.
Value investors typically seek out stocks with low P/E ratios, as they are on the lookout for undervalued stocks with the potential to grow. These investors believe that a lower P/E ratio indicates a greater opportunity for future gains.
On the other hand, growth investors are more likely to be drawn to stocks with high P/E ratios. They argue that a higher earnings growth rate warrants the elevated P/E ratio, despite the fact that the earnings themselves might not be particularly high.
P/E Ratio vs. PEG Ratio
There are two popular variations of the P/E ratio that can be particularly helpful: the forward P/E ratio and the price-to-earnings to growth (PEG) ratio.
The forward P/E ratio offers a way for investors to estimate a company’s future P/E ratio based on projected earnings for the upcoming fiscal year. It’s calculated by dividing the current stock price by the projected earnings per share (EPS) for the next 12 months.
Analysts and companies often supply these EPS projections, which can help investors determine if a stock is overvalued or undervalued based on its expected future earnings.
The PEG ratio takes things a step further by incorporating a company’s growth rate into the equation. This ratio is found by dividing the P/E ratio by the anticipated rate of earnings growth. A higher PEG ratio suggests that a stock may be overvalued, while a PEG ratio below 1.00 indicates that a stock is undervalued and could be a wise investment.
When using the PEG ratio, it’s worth noting that shorter projections can make the resulting ratio more dependable.
Morever, different sectors and industries often have varying average P/E and PEG ratios, so you should keep these differences in mind when making investment decisions.
Other Valuation Metrics
There are various ways to measure the worth of a stock or a company, and some methods may be more suitable for certain types of businesses.
Price/sales ratio
Price/sales (P/S) ratio is calculated by dividing a company’s market capitalization by its annual revenue. Unlike the price/earnings (P/E) ratio, the P/S ratio is based on revenue rather than earnings, making it a valuable tool for evaluating companies that are not yet profitable.
For established companies like Walmart, the P/S ratio may not be as relevant since they have consistent earnings. However, for companies like Amazon, which have a history of inconsistent earnings growth, investors still prefer to use the P/S ratio to evaluate them.
As of this writing, Amazon’s market cap is $1.7 trillion, and its fiscal year 2020 revenue is $386 billion, resulting in a P/S ratio of 4.4. When comparing P/S ratios of different companies, it’s crucial to only compare those with similar business models.
Across industries, P/S ratios can vary significantly due to differences in sales volumes, especially in industries with low profit margins where companies need to generate high sales volumes.
Price/book ratio
The price-to-book ratio is another metric that helps you understand a company’s financial health. By comparing the stock price to the book value per share (assets minus liabilities), you can get an idea of whether a company is undervalued or overvalued in the market.
Keep in mind, though, that the price-to-book ratio isn’t equally helpful for all companies. It works best for businesses with a lot of tangible assets, like banks and financial institutions.
For companies with fewer tangible assets, like software tech firms, the price-to-book ratio might not be as useful or accurate in assessing their value.
Other Factors to Consider
When diving into the world of investing, it’s all too common to fixate on numerical values like the price-to-earnings (P/E) ratio. However, seasoned investors understand that a company’s worth extends beyond these quantitative measures. Qualitative aspects, such as a robust economic moat or an extensive user base, can be equally crucial in predicting a stock’s potential.
For instance, a company boasting a solid economic moat is better equipped to stave off challenges from newcomers to the market. Likewise, businesses with vast user bases can capitalize on network effects, making it increasingly difficult for rivals to establish themselves. Moreover, a company with a relative cost advantage is more likely to generate higher profits in the long run.
Investors should also be mindful of other factors like industries characterized by steep switching costs, which deter customers from opting for competitors, and intangible assets like patents, regulations, and brand recognition, all of which can be immensely valuable.
It’s equally important to steer clear of value traps—stocks that seem attractively priced, but possess underlying issues rendering them unwise investment options. Examples include a pharmaceutical company nearing the expiration of a crucial patent, a cyclical stock at its peak, or a tech firm whose once-groundbreaking product is being outpaced by rivals.
As the renowned investor Warren Buffett advised, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
So, when assessing stocks, resist the temptation to focus solely on the numbers. Instead, examine the qualitative strengths and weaknesses that can significantly impact a company’s long-term success.
