Browse Instructions
How to Value a Stock
Posted By: hierh2dm;
Category: Business, Finance & Industrial;
December 1, 2008
Are you looking to invest some of your hard own money into stocks, but you’re a little confused on how to value them? Or maybe you would just like to know a couple different ways to determine whether or not a stock is a good buy. If so, this instruction will teach you how to value stocks in the stock market.
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One of the most important numbers you want to learn how to calculate is a stock’s P/E ratio. A P/E ratio is a stock’s price to earnings ratio (it is sometimes referred to as a stock’s multiple.) This number is usually already calculated for you on any number of financial websites. However, simply put, if a stock made $1 per share last year, and it is currently trading at $10 per share, the P/E is 10/1 or better stated as 10.
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Another important number to learn how to calculate is a stock’s growth rate. This number is important because a stock’s value is not based on what the stock is earning now, but on what the stock is most likely to earn in the future. In order to calculate this, you want to subtract the stock’s estimated future earnings by the stock’s current earnings. Both of these should be listed on a stock’s website or in the paper. Then you divide that number by the current earnings number (the one you used before) to find the growth rate. In order to make this number a percentage, simply multiply it by 100. For example, if a stock earned $.30 a share last year and is expected to earn $.70 a share this year, then you subtract .70 from .30, and you get .40. Then you want to divide that number by the current earnings again, which comes out to be about 1.3. Now multiply that by 100 and you get 13%.
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A good tip in valuing stocks is to look for stocks with a P/E ratio that is lower than their growth rate. For example, if you have already calculated that a stock has a growth rate of 13%, than you want to check what the stock’s P/E ratio is. If the P/E is 10, then it is most likely a good buy.
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A second way to use the P/E ratio and growth rate is to note that if the P/E ratio is double the growth rate (or more); it is definitely a strong signal to sell! Therefore, if your P/E is 20 and the growth rate is 10, it is time to look into getting rid of this stock.
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Another good strategy to valuing stocks is to look at a stock’s past growth rates. Look at what the stock has been doing throughout the years. If the growth rate is decelerating over time, then you do not want to own this stock.
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You also want to look at the sector as a whole. If you are trying to evaluate a tech stock, than look at all the tech stocks as a whole and try to get an average for what that sector in general is doing. This is the same for energy stocks, agricultural, retail, consumer staples, drug companies, etc. No matter how good a stock is, if the sector as a whole is down, then that stock will most likely follow.
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Another important and valuable number to look at is a stock’s PSR or Price/Sales Ratio. In order to find this number, divide a company’s total market value by the last four quarters of sales revenue. These numbers can be found on a company’s balance sheet. Whatever that number is, it shows you the price you are paying for each dollar of that company’s revenue. To determine value, compare that number to other PSR’s in the same sector. The less you are paying per dollar compared to other similar companies, is obviously the better!
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It is important to read a company’s balance sheet. This is also provided to you on any financial website. The balance sheet is a log of the company's assets and liabilities. It will show you what a company owns versus what they owe. It is good to look for companies with a lot of liquid assets and cash. Cash opens up a lot of opportunities for the stock going forward. If the company has more money then it needs to fund operations, it can give some back to shareholders by issuing dividends or buy backs.
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Return on Equity or ROE is often thought of as one of the best ways to measure a company’s success. Return on Equity is calculated by dividing net income by total shareholders’ equity. The bigger the better when it comes to this number. If it is a large number, that means the company is making a lot of money on the shareholders’ investments. Anything above 20% is considered a good return.
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