Dylan Lewis: People look at stock prices all the time, but how do you actually value a stock?
I’m Dylan Lewis from The Motley Fool. In this FAQ, we're going to walk through some
of the common ways that people value stocks and how you can use easy valuation tricks
to know what you're buying. One of the common approaches to valuing a
company is looking at the P/E ratio, this measures a company's current value against
how much it actually earns in income. And you can calculate it one of two ways, first,
by either taking a company's market cap and dividing it by net income or dividing a company's
current stock price by the company's earnings per share. So, if a company's stock trades
for $50, and there are 10 million shares outstanding, it is worth $500 million. And we'll say, for
this example, it has $25 million in net income. You can get the P/E ratio by dividing $500 million
by $25 million or by dividing the share price of $50 by the earnings per share
of $2.50. Either way you get a P/E ratio of 20. You’ll wind up with the same number
either way, because in the share price approach both numbers have already been divided by
the total number of shares the company has outstanding.
So, it's two different ways to the same place. Now, you’ll usually see the P/E ratio quoted
two different ways. Trailing twelve month or TTM, which looks at the company's actual
income over the past twelve months or forward. This approach takes an analyst estimate or
a series of analyst estimates, and looks at the earnings expectation for the company over
the upcoming year and then uses that as the earnings figure. If a company is growing,
its forward P/E ratio will always be smaller than its trailing twelve-month P/E ratio,
because more income is expected and the denominator will be larger.
If you see a P/E ratio out in the wild and it isn't specified which kind it is, you can
probably assume it's based on a company's trailing twelve-month earnings.
The P/E ratio only works if there's E or earnings. So, it's a helpful tool for companies that
have income, but it's totally useless if a company is not currently profitable,
that's why investors use another tool. For unprofitable companies, the P/E ratio
would return a negative number which wouldn't really be very helpful. So, instead, investors
use a price to sales ratio. This is the company's market cap divided by its total sales over
the past twelve months. High growth software companies can have price to sales ratios of
over ten, while more established businesses are usually in the mid- to low-single digits.
The P/E and P-S ratios are great because they allow you to normalize companies of different
sizes and immediately get a sense of what investors are willing to pay for a piece of
that company's earnings or revenue. You can use these ratios to compare how a company
stacks up to the overall stock market, peer’s in their industry or itself relative to the past.
Generally, businesses that are posting high
growth rates are going to have high price-to-earnings and price to sales ratios. That's because
investors expect that company to be considerably bigger in the future and they have bid up
shares to reflect that. That doesn't mean they're bad stocks to own, it just means that
people are expecting big growth to continue, and if it doesn't, shares could fall dramatically.
Conversely, stodgy, old businesses in crawling industries tend to have lower P/E ratios,
because they aren't growing very quickly. For them, this year's earnings will probably
look a lot like last years. The market isn't expecting much from stocks with low valuations,
so if the outlook gets worse, they're less likely to take a huge hit but they're also
less likely to give investors huge returns. By now you’ve probably realized that these
aren’t very complicated calculations to do. Valuation sounds scary to new investors,
but really all you're trying to do with these numbers is get a sense of how much you have
to pay for a dollar of earnings or revenue from a company and what the market expects
from that company. There's one more easy valuation metric you
can look at to see how a company’s valuation compares to the growth the company is posting;
and that's the PEG ratio. The PEG ratio takes the value from the company's
P/E ratio and then compares it to the company's earnings per share growth rate. So, to calculate it,
you first find the P/E ratio for a company and then divide it by the year-over-year earnings
growth rate. Going back to our $500 million business from
before, they have a P/E ratio of 20. Let's say that they grew their earnings per share
at 15% in 2019. Putting 20 over 15, we see that they have a PEG ratio of 1.33, the generally
accepted rule is that a PEG ratio of one represents a fair value, where anything under one is
cheap and anything over one is expensive, compared to the growth the company is posting.
For all these ratios, these rules aren’t absolute, just guidelines. As investors, we’re
looking for quality companies with good business models and exciting growth prospects, it's
worth paying a premium for companies like that. These metrics help us understand what
the premium looks like, and how it fits into the company's growth story.
There are more advanced ways of valuation, they usually involve spreadsheets, models
and discounted cash flows. Don't worry about that kind of stuff right now. If you have
these basics down, you'll be able to understand most conversations around how to value companies,
and most importantly, be able to understand what you're buying when you decide to buy a stock.
And if you're looking for help with investing,
we’ve got a free starter kit for you. Covers everything from opening a brokerage account
to buying your first stock and it comes with five great stocks to get you started.
You can get that for free over at fool.com/start. That's going to do it for this FAQ. We want
to know what stocks you're interested in and what questions you might have. Drop those
down in the comments section below. And be sure to hit that “thumbs up” button below
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Until next time Fool on!