Investors are always searching for methods to help them determine whether a company is worth investing in. There are many means of stock valuation, some simple, some more complex.
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 want to stay away. If the market price of the company’s stock is less than the company’s intrinsic value, the investor may want to buy the stock.
Price-to-Earnings Ratio (P/E)
The price-to-earnings ratio (P/E) is a widely used valuation methodology that compares a company’s current share price with its earnings per-share. Also known as the price multiple or earnings multiple, P/E is calculated by dividing market value per share (P) by earnings per share (E). It is used primarily to compare companies within the same industry. Investors often find it helpful to use projected earnings when calculating the P/E, so that the focus is on future expectations rather than past results. Value investors typically focus on stocks with low P/E ratios relative to their peers. Growth investors are less concerned with getting a bargain than with tapping into robust earnings momentum. Accordingly, growth stocks tend to have higher P/E ratios than value stocks, although some growth stocks may also feature a low P/E.
Price-to-Book Ratio (P/B)
The price-to-book ratio (P/B) measures a company’s market price in relation to its book value, which represents the total value that would be left over if the company liquidated its assets and repaid its liabilities. Book value can be found in the company’s balance sheet, usually listed as stockholder equity. A company’s P/B is calculated by dividing the stock price by its book value per share. It is most commonly used to value financial companies, which mark their assets to market daily. Like most ratios, it’s best to compare P/B ratios within industries. For value investors, the P/B ratio is a useful way to measure intrinsic value when earnings are low or negative, as in a start-up or fledgling company, or if the company’s earnings are erratic and not indicative of future trends. A high P/B relative to peers indicates that the stock may be overpriced, while a low P/B may point to a strong value. An extremely low P/B, however, often indicates other issues such as pending law suit or other business concern.
Price-to-Sales Ratio (P/S)
The price-to-sales ratio is used to determine a stock’s valuation relative to its sales. It is calculated by dividing the company’s price per share by its annual net sales per share. Like the P/E and P/B ratios, P/S is most useful when comparing companies within the same industry. The P/S ratio is used by both growth and value investors, especially when a company’s earnings are erratic or heavily managed. Like the P/B ratio, the P/S ratio is a good way to measure value when a company’s earnings are negative or jump around. Moreover, sales numbers are much harder for management to manipulate than earnings, which can easily be timed and tweaked. Source/Disclaimers 1Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
If you’d like to learn more, please contact David Chisholm. Article by McGraw Hill and provided courtesy of Morgan Stanley Financial Advisor.
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