When it comes to investing in the stock market, everyone wants to make a good investment. The old adage about buy low and sell high seems to be prevalent, even today. My first forays into the stock market were mostly through trial and error. It would have helped significantly if I had been taught how to value a stock before I started making financial investments.
The easiest way to value a stock is through the price-to-earnings ratio (P/E ratio). Stocks can also be valued based on their dividend yield, P/B ratio, and PEG ratio. When making a large investment, all four figures should be considered before any stocks are purchased.
If you want to start off your investing the right way, here is everything you need to know about how to value a stock before you invest the first dollar.
For most investors, the best way to value a stock is through looking at the company’s price-to-earnings ratio, often abbreviated to P/E ratio. The formula for calculating this ratio is simple but may require some research on your part.
In order to calculate the P/E ratio, you will need to know the company’s current stock price and their reported earnings per share. Divide the stock price by the earnings per share (EPS) and you will come up with their ratio. The formula should look something like this:
Price-to-Earnings Ratio = Current Stock Price/Reported Earnings per Share
Valuing a stock according to this ratio is relatively simple. If you are seeing a relatively low ratio, then the stock is considered to have a decent amount of value. A higher P/E ratio demonstrates that you might be paying too much for the stock or that it is overvalued.
On the other hand, a high P/E ratio could indicate that the company is poised to grow quickly. Investing in a stock with a higher ratio is only a good idea if you truly believe that the higher share price will yield large growth expectations in the future. This can be particularly true for businesses in certain industries, such as tech startups.
What is the difference between a high and low P/E ratio? It can help to look at the history of the S&P 500 for guidelines.
The average ratio for stocks that trade here usually ranges between 13 and 15. A higher ratio than this could mean either tremendous growth is expected or the stock is overvalued. Do your research on the background of the company and what is on the horizon before committing to purchase.
The truth is that there is not one simple answer when it comes to what P/E ratios you should consider. It boils down to what type of investments an investor wants to make and how much risk they are comfortable including in their portfolio.
A one-size-fits-all answer about what P/E ratio does not really exist. Instead, investors must determine whether they are more interested in value or growth.
When it comes to how to value a stock, growth investors often prefer buying a stock with a higher ratio. For those who subscribe to this type of investing philosophy, they often believe that a ratio that represents a higher investment indicates a higher rate of earnings growth.
On the other hand, a value investor typically looks for a low P/E ratio because they prefer to see the potential for growth. They are looking at stocks that are underappreciated by the market or stocks that appear cheap for the revenue and earnings that a business reports having.
One of the key tenets of a value investor is that they are looking for a good opportunity with minimal risk involved. Because stocks with a low P/E tend to be less expensive, they have more of a cushion built into their investments. This makes them feel a bit safer when it comes to taking a chance on adding a new company to their portfolio.
Another key metric that you might use to value a stock is looking at the dividend yields. This number tells you how much a company will pay out in dividends each year in comparison to the overall stock price. In other words, you are performing a calculation that looks like this:
Dividend Yield = Price/Dividend Ratio
The result should give you a percentage that indicates how much “interest” you are earning on this investment.
Most of the time, dividend yields are only offered by mature companies. Some industries such as utilities are more likely than others to have larger dividend yields. When it comes down to how to value a stock based on dividend yields, a larger percentage is almost always better than a lower one.
Keep in mind that the answer is not always as straightforward as you might imagine it to be. In fact, you will want to look at the historical data for the company to see if they have been able to consistently pay dividends year over year. If you notice that they have had inconsistent dividends with periods where they have suspended payments, it might not be a wise investment.
There are also some companies and industries that do not produce high dividend yields but could still be a great investment for you. While utilities often pay some of the highest dividend yields, tech industries often offer meager dividend yields because the startup is more focused on making an investment back into the business for continued growth.
Not to be confused with the P/E ratio, the P/B ratio is another important measurement that some investors will use when valuing a stock. It stands for the price-to-book ratio and it measures the value of the company if it were to be sold on this very day. In other words, it follows this simple formula:
Price-to-Book Ratio = Company’s Share Price/Book Value Per Share
This ratio can be especially helpful for investors who are concerned that their investments might start to weaken or fade over time. Even though a company may be declining in terms of its profit or growth, the assets that they hold could still turn a profit. The book value of the company will typically include important assets such as:
Keep in mind that assets can fluctuate depending on what holdings a company has. This is true particularly for companies that have a portfolio of assets that includes stock holdings or bonds. On the other hand, some businesses have more physical assets that depreciate over time.
Think long and hard about what type of assets the company holds and how secure those will be over time when calculating the P/B ratio. A little bit of research into what assets a company holds can be extremely useful when calculating the price-to-book ratio.
When you want to dive a little deeper into the value of a stock, investors may choose to look at the PEG ratio which stands for the price-to-earnings-growth ratio. This number allows investors a more comprehensive look at the historical earnings of a particular company. This also makes it much easier to compare one company to another for investors who are on the fence about where they want to invest their dollars.
How do you calculate the PEG ratio? All you have to do to come up with this ratio is take the P/E ratio and divide by the year-over-year growth rate of its earnings.
Investors will know if a stock is a solid deal by taking a look at their final calculations. A lower PEG ratio often indicates that investors are getting a better deal by investing in this stock based on the potential for future earnings.
However, many investors still aren’t sure where to draw the line on a “good” PEG ratio. Experts recommend that you aim for a PEG of one or less. At a ratio of one, you will be just breaking even if things carry on the way they have historically. PEG ratios that are under one often indicate that a stock is fairly priced or potentially even undervalued. This can be a great time to get in on the ground floor with a new stock.
On the other hand, when you get to a PEG of 2 or higher, investors are paying more for projected growth.
In the end, you need to do plenty of research to determine whether you feel that the stock will continue to grow in the same manner that it has historically. Is there a new trend in the market that will inhibit its growth or did they just release a new product that is flying off the shelves?
If you can narrow down some of these questions and concerns, then you might feel more at ease in making an investment. Investors should also be sure to compare the PEG ratios of the different investments that they might be considering. This enables them to see which stocks are the best investment for their portfolio, particularly when used in combination with the other methods of valuation on this list.
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Figuring out how to value a stock doesn’t have to be as complicated as some investors have made it out to be. Anyone can learn the basics of calculating a price-to-earnings ratio using the simple formula that we covered. Whether you decide to invest in companies that have a high ratio or a low one is completely up to you and your investment strategy.
Of course, it can also be helpful to look at other secondary measurements that indicate how well a stock is performing and how to value a stock. You might take a closer look at their dividend yield, P/B ratio, or their PEG ratio (or a combination of all three) before you make an investment in any one stock.
By looking at all four measurements, you can get a comprehensive glimpse at how the stock is currently performing, how it has performed historically, and how many assets they currently have at their disposal. You should be certain to do as much research as possible before investing, even if it feels like you will never get a better deal than the one in front of you right now.
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