A common mistake for a beginning investor is equating low price per share stocks, such as penny stocks, as inexpensive stock price. After all, it feels intuitive that a $1 stock is less expensive than a $10 stock. Unfortunately, this is the wrong way to think. The first thing you need to know about stock investing is that the share price by itself doesn’t give you enough information about its value.
To gain a better understanding of a stock value, you can start by examining its fundamentals. However, there are too many ways to look at the fundamentals, so I will just introduce you to the four commonly used ones.
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The first and most common way to value a stock is using the Price-Earnings Ratio, or P/E ratio. The P/E ratio is a valuation ratio that compares a company’s current share price to its earnings per share (EPS). The P/E ratio is sometimes referred to as the earnings multiple, or just multiple, because it indicates how much money investors are willing to pay for one dollar of earnings.
For example, if a company is currently trading at $25 a share and earnings over the last 12 months were $2.50 per share, the P/E ratio for the stock would be 10 ($25/$2.50). In term of multiple, this means investors are willing to pay $10 for $1 of earnings.
Usually, EPS is from the last four quarters (trailing P/E), but sometimes estimates of earnings expected in the next four quarters (projected P/E or forward P/E) or even a combination of the two methods is used by investors to perform their stock valuation.
In general, companies with a higher P/E are expected to have a higher earnings growth in the future compared to companies with a lower P/E. However, you have to be careful when comparing companies from different industries. For example, technology companies tend to have higher P/E than utilities companies, etc.
Next is one of my favorite ratio, Price/Earnings To Growth ratio, or PEG ratio, is an improvement over P/E ratio in a sense that it also takes a company’s growth into account. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. The PEG ratio is figured by taking the P/E ratio and dividing it by the earnings growth rate. For example, if a company has a P/E ratio of 10 and a growth rate of 8% per year, its PEG ratio would be 1.25 (10/8).
However, you should note that the earnings growth rate is a projection and as such, this ratio can be less accurate.
This is another variation of the P/E ratio and PEG ratio that takes dividend yield into account. The PEGY ratio is figured by taking the PEG ratio and dividing it by the dividend yield. For example if a company has a PEG ratio of 1.25 and a dividend yield of 2.5%, its PEGY ratio would be 0.5 (1.25/2.5).
Again, a lower PEGY ratio is an indication that a company might be undervalued. However, you really have to be careful when using this ratio because (1) not all companies offer dividend, (2) various industries have significantly different average dividend, and (3) big price swing can seriously affect the dividend yeild since it’s a function of share price.
The Price-To-Book ratio, or P/B ratio, compares a stock’s share price to its book value (the value of a company’s total asset according to its balance sheet). The P/B ratio is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. For example, if a company stock price is $25 and the book value per share is $16.50, its P/B ratio would be 1.52 (25/16.5).
A lower P/B ratio means that the stock might be undervalued. In general, this ratio gives you an idea of what would be left if the company went bankrupt today.
Okay, I’ll stop right here instead of boring you to death with all these ratios. The point I was trying to make is that you cannot simply decide if a company is a good buy or not just by looking at its price. Hell, you can’t even tell by looking at all these ratios above, because there is a lot more due diligence that you must go through. That’s why individual investors are better off staying away from individual stocks. And for those who argue otherwise — yes, there are investors who do really well picking individual stocks, but they are exceptions, not the rule.