Why is stock valuation so important? If the market price of the company’s stock is greater than the company’s intrinsic value, an investor might choose to stay away. If the market price of the company’s stock is less than the company’s intrinsic value, the investor may choose to buy the stock.
Here are six key valuation methods:
Price-to-Earnings Ratio (P/E)
The price-to-earnings ratio (P/E) is a valuation method used to compare a company’s current share price with its per-share earnings. Its formula is calculated by dividing its market value per share by its earnings per share. The P/E is one of the most widely used ratios, and it is used to compare the financial performance of different companies, industries, and markets. The company’s forecast P/E (its P/E for the upcoming year) is generally considered more important than its historical P/E.
Price-to-Earnings Growth Ratio (PEG)
The P/E ratio is a snapshot of where a company is, and the PEG ratio is a graph plotting where it has been. The PEG ratio incorporates the historical growth rate of the company’s earnings. This ratio also tells you how your stock stacks up against another stock. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings.
Price-to-Book Ratio (P/B)
The price-to-book ratio measures a company’s market price in relation to its book value. Its formula is calculated by dividing the company’s stock by its book value per share. Book value can be found in the company’s balance sheet, usually listed as “stockholder equity.” It represents the value of a company’s total assets subtracted by its total liabilities. The P/B does not consider the actual value of the assets, only the nondepreciated portion of the assets. Like most ratios, it’s best to compare P/B ratios within industries. For example, tech stocks often trade above book value, while financial stocks often trade below book value.
Price-to-Sales Ratio (P/S)
The price-to-sales ratio helps determine a stock’s relative valuation. Its formula is calculated by dividing the company’s price per share by its annual net sales per share. Price-to-sales ratio is considered a relative valuation measure because it’s only useful when it’s compared with the P/S ratio of other firms. The P/S ratio varies dramatically by industry, so when comparing P/S ratios, make sure the firms are within the same industry.
Return on Equity (ROE)
The ROE is calculated by dividing a company’s earnings per share by its book values per share. The ROE is a measure of how well the company is utilizing its assets to make money. Understanding the trend of ROE is important because it indicates whether the company is improving its financial position or not.
Dividend Payout Ratio
This ratio is calculated by dividing the dividends paid by a company by its earnings. The dividend payout ratio can also be calculated as dividends per share divided by earnings per share. A high dividend payout ratio indicates that the company is returning a large percentage of company profits back to the shareholders. A low dividend payout ratio indicates that the company is retaining most of its profits for internal growth.
1Investing in stock involves risk, including loss of principal.