Here’s how to find bargains.
Anyone who has spent more than 10 minutes reading about stocks has come across the terms “overvalued” and “undervalued.” And if you do a little more digging, you’re bound to find that plenty of stocks that look “cheap” to one financial pundit or another, but “expensive” to others. So, how exactly can you figure out the value of a stock? The answer is, “it depends,” and that’s why there are a number of different metrics that aim to answer that question under different situations. Here are some common formulas.
Price-earnings ratio (P/E)
The price-earnings ratio is one of the simplest and most common valuation metrics. Take the price per share and divide it by earnings per share, and you have your P/E. The lower the P/E, the less Wall Street “values” it. While many investors use trailing 12-month earnings because they’re actual, tangible results, many like using “forward” estimates for the next year. After all, investors care most about the future, not what a stock’s already done.
EXAMPLE
Stock X price = $20/share
Previous year’s earnings = $2/share
P/E = 10
Price/earnings-growth ratio (PEG)
Some sectors, like utilities, typically trade at low P/Es, reflecting low expectations for future growth. Tech companies, however, often trade at high P/Es because investors are banking on rampant growth down the line. Price/earnings growth (PEG) is the great equalizer, though, factoring growth expectations into valuation. The calculation for this is P/E divided by annual earnings per share growth. With PEG, less than 1 is considered undervalued, and anything over 1 is considered overpriced.
EXAMPLE
Stock X P/E = 11
Estimated 5-year annual earnings growth: 11 percent
PEG = 1
Price-sales ratio (P/S)
Not every company has earnings. But they do have revenues, so investors use price-sales. Again, a low P/S is “cheap,” and a high P/S is “expensive.” Twitter (ticker: TWTR) was flagged for having a high P/S early after its initial public offering that was more than double of Facebook (FB). However, that corrected amid disappointing results, with Twitter’s P/S dropping from nearly 30 in December 2013 to about 5 as shares plunged more than 70 percent.
EXAMPLE
Stock X price = $20/share
Previous year’s revenues = $4/share
P/S = 4
Price-book (P/B)
“Book value” is a grim figure that essentially represents the assets that would be left over — buildings, machines, etc. — if a company suddenly went out of business. It’s calculated by taking total assets and subtracting intangible assets and liabilities. While a P/B of 1 or less signals a company is undervalued, P/B isn’t always useful. For instance, tech companies like Priceline Group (PCLN) typically have few tangible assets, making this a weak measurement.
EXAMPLE
Stock X price = $20/share
Previous year’s book value = $25/share
P/B = 0.8
Price-dividend (P/D)
Price-dividend is a lesser-used metric that’s good for measuring dividend stocks. It’s the opposite calculation of dividend yield — instead of dividing dividend by price, you divide price by dividend. This ratio essentially tells you how much you have to pay to receive $1 in dividend payments. This is most useful in comparing a stock’s value against itself (does it cost far less for that $1 in dividends than it used to?) or against other dividend payers.
EXAMPLE
Stock X price = $20/share
Previous year’s dividend = $1/share
P/D = 20
Enterprise value-sales (EV/S)
Enterprise value is an alternative (that some think is superior) to market capitalization, as it factors debt into the system. Thus, enterprise value-sales is just an alternative to price-sales. EV is calculated by taking the market cap, then adding total debt (including preferred shares and minority interest) and subtracting cash and cash equivalents. Some favor this calculation in valuing companies that could be taken over, as debt and cash would be factored into a transaction.
EXAMPLE
Stock X EV = $25/share
Previous year’s revenues = $5/share
EV/S = 5
Enterprise value-EBITDA (EV/EBITDA)
Just like EV/S is an alternative to P/S, EV/EBITDA is an alternative to P/E. EBITDA stands for earnings before interest, taxes, depreciation and amortization, and is thought to be a more accurate representation for how a company is actually performing — mostly because it backs out various factors that can be altered by creative accounting. EV/EBITDA is not something you’re going to see often, but many say it’s a more accurate representation of a company’s valuation.
EXAMPLE
Stock X EV = $25/share
Previous year’s EBITDA = $2.50/share
EV/EBITDA = 10
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