We’ve come this far without yet talking about stock price. Or, more to the point, valuation. Consider that a stock whose share price is $100/share is not necessarily more “expensive” than a stock going for $40/share, because the higher price may correspond to higher-value shares. When evaluating the price of a stock, investors compare the share price (market value) to what they think the underlying or intrinsic value of those shares are, in order to determine if it is a good time to buy or sell it. This process is called valuation.
There are many methods people use for valuation, so one person’s “expensive” might be someone else’s “fairly valued.” Furthermore, different investing strategies differ on how important valuation is; some strategies (like value investing) are highly sensitive to pricing, while others (like growth investing) are less so. So, reasonable people can disagree about the value of a stock, and about how much the perceived value even matters in the decision to purchase. Most fundamental investors give valuation some, if not significant, consideration in their trading decisions.
For new investors, it may be helpful to think about it this way: not only do you want to purchase good companies (good fundamentals), but you want to purchase them at good prices (good value).
Let’s take a look at common metrics investors use to determine a stock’s value.
Price/Earnings
The most common method of valuation is to simply divide the share price by a company’s current earnings per share (EPS). This gives the price/earnings ratio (P/E), which tells you how much you are paying per dollar of earnings (profit) that the company makes. It is also referred to as the “P/E multiple” and it is usually one of the key pieces of data included with a stock quote.
Example:
- Company A has a stock price of $100/share and an EPS of $7. You are paying $100 for each $7 of its earnings, or a P/E multiple of about 14.3.
- Company B that has a stock price of $40/share and an EPS of $2.50, giving it a P/E multiple of 16.
If you look at P/E alone, the $40 stock is actually more expensive than the $100 stock. You are paying more for each dollar of earnings. This alone does not mean that the $100 stock is the better pick—to determine that, you would also want to analyze its fundamentals—but it provides you with another data point to consider when making your trade decisions.
Since stock prices change throughout the day (while the “E” part of the equation only changes quarterly with the income statement release), the P/E may help you determine a good price to buy a stock you consider to have good fundamentals. For example, you might like Company B, but want to see its P/E come down below 15 before buying. Alternatively, you might be holding a stock whose P/E has gone higher and higher; this might tell you that it’s time to sell before the bubble bursts.
Forward Price/Earnings
Forward P/E is similar to the P/E discussed above (sometimes called trailing P/E), except it compares the current price to estimated future earnings rather than current earnings. A company that is expected to grow its EPS in the next year may have a lower forward P/E than current P/E.
If the earnings grow as estimated and the market continues to value the shares in the future as it has done in the past, the stock price will grow. Some investors consider forward P/E to be more relevant than trailing P/E.
High expectations about growth are why hyped or fast-growing companies tend to have high multiples—shares are marked up because investors expect the company to make great returns in the future. Shares can also get marked up (or down) for other market reasons that may or may not have to do with the quality of the company. This is one reason why figuring out the price at which to trade a stock is more an art than a science, and there are always buyers and sellers of the same stock at any point in time.
Other Common Valuation Metrics
Although P/E is most commonly cited, it’s not the only valuation metric. Other multiples you can use are price/book, price/bsales, price/free cash flow, and EV/EBITDA. All of these compare pricing to some aspect of a company’s worth in some way. In all cases, a lower number indicates a less expensive valuation. Get definitions of all of these on our Valuation Metrics page.
These metrics by themselves don’t provide you with the context you’ll need to tell if a price is high, low, or or somewhere in between. As with other metrics discussed in earlier chapters, getting both industry and historical context is necessary for a clearer picture of valuation. Some sectors and industries have higher multiples in general, so what might seem like a high valuation could be average or even low compared to peers. Likewise, what might seem like a middling valuation might actually be a historical high for that particular stock, which means it might not be the optimal time to buy.
You can ask about a stock you are interested in:
- How do current valuation metrics compare with industry averages?
- How does current valuation compare with historical valuation?
- If the valuation seems high, is it justified by high expected earnings growth?
- If the valuation seems low, is it possible that the market is undervaluing a gem, or is the price discounted for good reason?
Your qualitative and quantitative research will help you answer these questions. Your answers, along with how much you personally weigh valuation in your investment decision making, will help you determine if and at what price you want to buy a stock.
Exercises:
Practice valuation with the following exercises. For where to find this information in Stock Rover, see this appendix.
- Find the P/E multiple for a stock you are interested in.
- Compare this multiple to the industry average.
- Chart the P/E for this stock over the last year, and look at the 5-year P/E range.
- Find the forward P/E. Is this higher or lower than the trailing P/E?
- What do you think of the stock’s valuation? Would you buy the company at this price? Why or why not? What price might you consider buying at?
Next: Risk Considerations
This guide was created in partnership with bivio, which provides online investment club accounting and hedge fund management services.
