Arguably the most important skill investors can learn is how to value stocks. Without this competence, investors cannot independently distinguish whether a company’s stock price is low or high relative to the company’s performance and growth prospects.
What is an arrow?
One share of the company represents a small ownership stake in the business. As a shareholder, the percentage of company ownership is determined by dividing the number of shares you own by the total number of shares outstanding and then multiplying that amount by 100. Owning stock in the company generally gives the owner of the stock the institutional voting rights and income from any dividends paid.
Why assign values to stocks?
The intrinsic value of the stock, rooted in the fundamentals of its business, is not always the same as the current market price – although some believe otherwise. Investors assign values to stocks because it helps them decide if they want to buy them, but there is not only one way to value a stock.
At one end of the spectrum, active investors—those who believe they can develop and implement investment strategies that outperform the broader market—value stocks based on the belief that a stock’s intrinsic value is completely separate from the market price. Active investors calculate a series of metrics to estimate the intrinsic value of a stock and then compare that value to the current market price of the stock.
Passive investors subscribe to the efficient market hypothesis, which assumes that a stock market price always equals its intrinsic value. Passive investors believe that all known information is already priced in a stock, and therefore its price accurately reflects its value. Most believers in the efficient market hypothesis suggest simply investing in an index fund or an exchange-traded fund (ETF), rather than doing the seemingly impossible task of outperforming the market.
The metric for valuing the underlying stock is the price-to-earnings ratio
The most common method of valuing a stock is by calculating the price-to-earnings (P/E) ratio. The price-to-earnings ratio is equal to the company’s stock price divided by the last reported earnings per share (EPS). A low P/E ratio indicates that the investor who buys the stock is receiving an attractive amount of value.
As an example, let’s calculate the price-to-earnings ratio for Walmart (NYSE: WMT .).
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). In its fiscal year 2021, which ended January 31, 2021, the company reported diluted earnings per share of $4.75. At the time of writing, the company’s share price is $139.78.
To get Walmart’s P/E ratio, simply divide the company’s stock price by EPS. Dividing $139.78 by $4.75 results in a P/E ratio of 29.43 for the retail giant.
Use GAAP vs. Adjusted Earnings to Determine the P/E Ratio
GAAP is an acronym for Generally Accepted Accounting Principles, and a company’s GAAP earnings are those according to which it is reported. GAAP earnings are the amount of profit they make on a non-adjusted basis, meaning without regard to non-recurring or unusual events such as business unit purchases or tax incentives received. Most financial websites report P/E ratios that use GAAP-compliant earnings numbers.
Non-recurring events can cause significant increases or decreases in the amount of earnings generated, which is why some investors prefer to calculate a company’s P/E ratio using the earnings per share figure adjusted for the financial effects of one-time events. Adjusted earnings numbers tend to produce more accurate P/E ratios.
Continuing with the example above, Walmart’s P/E ratio of 29.43 was calculated using unadjusted earnings (GAAP) of $4.75. The company, in its fourth-quarter earnings report, states that adjusted earnings per share for the same period is $5.48. The adjusted EPS number represents losses related to Japan and UK operations, gains from their equity investments, and the effects of restructuring fees.
Using the adjusted EPS value, we can calculate Walmart’s P/E ratio as 25.50 – the result of dividing $139.78 by $5.48.
What is a good P/E ratio per share?
A good P/E ratio for one investor may not be attractive to another. P/E ratios may be viewed by different investors differently depending on their investment objectives, which may be more value or growth oriented.
Value investors directly prefer lower P/E ratios. A stock whose implied market valuation is well below its intrinsic value is likely to be attractive to value investors.
Growth investors are more likely to buy stocks with a higher P/E based on the belief that the superior rate of earnings growth, if not the absolute value of earnings themselves, justifies a higher P/E ratio.
How Investors Can Use Differences in the P/E Ratio
Investors, especially growth-oriented, often use a company’s current and past price-to-earnings ratios to calculate two other metrics: the forward-looking price-to-earnings ratio and the price-earnings-to-growth (PEG) ratio.
How Investors Can Use Differences in the P/E Ratio
Investors, especially growth-oriented, often use a company’s current and past price-to-earnings ratios to calculate two other metrics: the forward-looking price-to-earnings ratio and the price-earnings-to-growth (PEG) ratio.
The forward price-to-earnings ratio is easy to calculate. Using the formula for the P/E ratio — the stock price divided by earnings per share — the forward P/E ratio replaces the EPS from the subsequent 12 months with the company’s projected EPS over the next fiscal year. Projected EPS numbers are provided by financial analysts and sometimes by the companies themselves.
The price-earnings-growth (PEG) ratio represents the rate at which a company’s earnings grow. It is calculated by dividing the company’s P/E ratio by the expected rate of growth of its earnings. While most investors use the company’s projected growth rate for the next five years, you can use the projected growth rate for any length of time. The use of growth rate forecasts for shorter periods of time increases the reliability of the P/E ratio and the resulting growth.
Continuing with our Walmart example, analysts expect annual EPS growth over the next five years to average 6.29% annually. Dividing Walmart’s P/E ratio from 29.43 to 6.29 results in a PEG ratio of 4.67. A stock with a price-earnings-growth (PEG) ratio of less than 1.00 is exceptional value due to its impressive growth rate expected.
Other rating scales
Many metrics can be used to estimate the value of a stock or a company, with some metrics being more appropriate than others for certain types of companies.
Price/sales ratio
Besides the price-to-earnings ratio, another common metric used to value stocks is the Price/Sales (P/S) ratio. The P/S ratio equals the company’s market capitalization — the total value of all shares outstanding — divided by its annual revenue. Since the P/S ratio is based on revenue rather than profit, this metric is widely used to evaluate public companies that do not have profits because they have not yet made profits. Strong companies with steady earnings like Walmart are rarely evaluated using a P/S ratio. Amazon (NASDAQ:AMZN)
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) has a history of inconsistent earnings growth, so despite its massive size, the price-to-value ratio is a metric that investors still prefer to use to rate an online retailer.
Amazon’s market capitalization at the time of writing is $1.7 trillion and its revenue for fiscal year 2020 is $386 billion. Dividing $386 billion into $1.7 trillion results in a P/S ratio for Amazon of 4.4.
Investors who want to compare the P/S ratios of different companies should be careful to compare only the P/S ratios of companies with similar business models. Across industries, P/S ratios can vary greatly because sales volumes can vary greatly. Companies operating in industries with low profit margins usually need to generate high sales volumes.
Price/book ratio
Another useful metric for valuing a stock or company is the price-to-book value ratio. The price is the company’s share price and the book indicates the book value per share of the company. The book value of a company is equal to its assets minus its liabilities (asset and liability figures are found in companies’ balance sheets). The book value per share of a company is simply equal to the book value of the company divided by the number of shares outstanding.
A company’s P/B ratio is only marginally useful for valuing companies, such as software technology companies, that have asset-light business models. This metric is more relevant for evaluating asset-heavy businesses, such as banks and other financial institutions.
It’s a (value) trap!
The stock can seem cheap, but in fact, due to the deteriorating working conditions, it is not. These types of stocks are known as value traps. The value trap may take the form of a pharmaceutical company’s stock with a valuable patent that expires soon, periodic stock at the height of the cycle, or the stock of a technology company whose once-innovative offering is being converted into a commodity.
Other factors related to inventory valuation
Aside from metrics such as the price-to-earnings ratio being quantified, investors should consider the qualitative strengths and weaknesses of companies when measuring a stock’s value. A company with a defensible economic moat is better able to compete with new market participants, while companies with large user bases benefit from network effects. A company with a comparative cost advantage is likely to be more profitable, and companies operating in industries with high conversion costs can retain customers more easily. Quality companies often have intangible assets (for example, patents, regulations, and brand recognition) that are highly valuable.