Stock investors use various strategies and metrics to calculate the intrinsic value (or theoretical value) of stocks they buy. Stock valuation, also known as price-to-earnings (P/E) ratio, is one method most commonly used to determine whether a stock is overvalued, undervalued or fairly priced relative to supply, demand and market conditions.
So, why is this important? Because without stock valuation, yourself as an investor may miss out on cashing in solid returns or making a profit from your investments. In the worst-case scenario, you could actually end up losing money if you’ve bought equity shares for a price that has nowhere to go but down.
What is price-to-earnings (P/E) ratio?
The price-to-earnings (P/E) ratio is one of the most widely used metrics investors and analysts use to conduct a stock valuation. The P/E ratio measures how much investors are paying for a stock based on its past or future earnings.
P/E ratio compares a company's stock price to its annual earnings per share (EPS). It’s calculated by dividing the stock price (market value) by the stock's earnings. By dividing the stock price of a company by its annual earnings per share, you get a number that tells you how much you’re paying for each dollar of that company’s earnings. For example, if a company is trading at $15 per stock and its earnings over the past financial year were $1.10 per share, then the P/E ratio for the stock would be calculated like this − 15/1.10 = 13.63.
Put differently, if you would acquire the whole company and pay in cash, the company would have to produce the same profit for the next 13.63 years until your takeover would give you a positive return.
In addition to determining whether a company's stock price is overvalued or undervalued, the P/E can also show you how that company fares against its industry group or entire stock indexes like the S&P 500 or Dow Jones.
Keep in mind, however, that stock price and P/E ratio aren’t correlated. The market price of a stock shows you how much people are willing to pay to own that stock. The P/E ratio tells you whether the price reflects the company’s earnings potential or its predicted value over time.
What is a good price-to-earnings (P/E) ratio?
P/E ratios vary between sectors, industries and markets over time. That’s why there is no magic number for what is considered a good P/E ratio. A good P/E ratio in one industry or asset class can be not so crash hot in another and vice versa. However, many value investors consider that lower is better, based on the assumption that these companies have a capacity for further growth and can offer higher returns in the long term.
Now, let’s talk money. For example, if a company has a P/E of 13, it means investors are willing to pay $13 for every dollar of company earnings. Simply put, it would mean that the company’s market value is equal to 13 times its annual earnings. Another way to think about it is that if you hypothetically bought 100% of the company’s stocks, it would take you 13 years to earn back (through the company’s profits) what you initially paid for each share.
The current average (2021) P/E for the S&P 500 index is 37.26 (which is 90% above the modern-day market average of 19.6), and the current average P/E for the Dow Jones is 29.42, according to the Wall Street Journal. Both of these would be considered quite high by historical standards.
Is it better to have a higher or lower price-to-earnings (P/E) ratio?
As mentioned, there’s no magic number for what is considered a good P/E ratio, because the price-to-earnings ratio is not a straightforward calculation and it won’t tell you everything you need to know about a stock. It’s more of an indication of whether the price of a stock is reflective of the company’s earnings potential and value over time. Take it with a grain of salt.
To illustrate this point − a high P/E could mean that a share price is high compared to that company’s earnings and therefore overvalued, or it could be a sign that investors are willing to pay a higher share price today because they have high growth expectations in the future. Anecdotally, companies that experience faster than average growth, like tech companies for example, typically have higher P/Es.
On the other hand, a low P/E could indicate that the current stock price is low relative to earnings and therefore undervalued. Some investors do prefer to invest in low P/E stocks as it could suggest expectations aren’t too high and the company is more likely to exceed earnings forecasts, which could mean higher returns on investment.
P/E variation: Shiller P/E
One disadvantage of the P/E ratio is that the company can influence it by bookkeeping measures. If they make provisions for lawsuits (it goes down) or put in a higher value for property they own (it goes up). Another case they can manipulate the P/E is if they take over another company. Normally the price they pay is not booked in one year. They spread the money they paid over 10 or 20 years and put the rest as goodwill in their books. Therefore the Nobel Prize winner Robert Shiller developed a P/E version that should be more objective. Therefore he takes as earnings the average of ten years of earnings, adjusted for inflation. For long term investors we recommend to focus on this P/E version.
The 4 basic metrics of stock valuation
How do you determine the value of a stock? Besides the price-to-earnings (P/E) ratio, there are other metrics that investors use to assess a stock's value. Use these four metrics COMBINED for stock valuation.
- Price-to-earnings (P/E) ratio (H3)
We’ve covered this in detail but remember that P/E, also known as the ‘price multiple’ or ‘earnings multiple’ compares a company’s stock price to its annual earnings per share. This ratio simply determines what the market (investors) is willing to pay for a particular stock based on its current earnings and future projections.
- Price-to-earnings-to-growth (PEG) ratio (H3)
This compares a company’s stock price to its earnings per share and rate of growth. PEG ratio is used to measure the value of a company's stock based on the growth potential of its earnings. It’s the ratio investors use to compare how company A's stock stacks up against company B's stock.
- Price-to-book (P/B) ratio (H3)
This compares the market value of a company's stock price to its book value per share. The book value of a company is the difference between its total assets and liabilities, and is not its share price in the market. In other words, the P/B ratio represents the value of the company if it was dissolved and sold today.
- Dividend yield (H3)
This ratio shows how much a company pays out in annual dividends to its shareholders, relative to its stock price. This figure is typically expressed as a percentage of the stock's current price and can help investors work out how much passive income they could generate in the future. Just keep in mind that dividend yields can change over time, due to market fluctuations or changes to dividend payments approved by the issuing company.
How to assess a stock
Conducting a thorough stock valuation is important to ensure you’re investing in the right stocks and for the right reasons, taking into account your financial goals and needs. The first thing to do when thinking about buying stocks is to research the company and look at its financial statements. Once you get an idea that the company you’re thinking of investing in stacks up, it’s time to evaluate its price-to-earnings (P/E) ratio, which compares the company’s stock price to its earnings per share. There are also other metrics to consider like price-to-book (P/B) ratio, which compares that company’s market capitalisation to its book value and of course, dividend yield if applicable, and so on. If you’re a novice investor, however, you should not attempt to carry out a stock valuation on your own. Talk to a financial advisor to help you better understand how stock valuation metrics work and what they mean. A financial advisor can also help you devise an investment strategy that includes the right combination of value and growth stocks.
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