The cornerstone to valuing stocks: The P/E ratio - Deepstash
The cornerstone to valuing stocks: The P/E ratio

The cornerstone to valuing stocks: The P/E ratio

The go-to metric for nearly all investors when it comes to valuing a stock has to be the P/E ratio. Standing for price-to-earnings, this formula is calculated by dividing the stock price by the earnings per share (EPS). The lower the P/E ratio, the more earnings power investors are buying with each share.

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MORE IDEAS FROM The Definitive Guide: How to Value a Stock

The Price Sales Ratio

While using the P/E ratio as a building block is probably the most popular method to value stocks it is far from the only way. Another common technique to valuing stocks is the price/sales ratio. The P/S ratio is determined by dividing a company's market cap -- the total value of all the companies outstanding shares -- by its annual revenue. Because this ratio is based on revenue, not earnings, it is widely used to evaluate public companies that are not yet profitable and rarely used on stalwarts with consistent earnings such as Walmart

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What is A Share?

A single share of a company represents a small, but real, ownership stake in a corporation.

One stock's percentage of ownership is determined by dividing it by the total number of shares outstanding.

Stock ownership generally entitles the owner to corporate voting rights and to any dividends paid.

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Final thoughts on valuing a stock

There's more to valuing a stock than just crunching numbers. Investors have to take into careful consideration qualitative factors also, such as a company's economic moat. Moats encompass companies' competitive advantages, such as a network effect, cost advantages, high switching costs, or intangible assets (e.g. patent, regulations, or brand recognition).

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Price-to-book Ratio

Another metric useful for evaluating some types of stocks is the price-to-book ratio.

How to calculate?

  1. Assets-Liabilities = Book value
  2. Book value/Outstanding shares = Book value per share
  3. Share price/book value per share = Price-to-book ratio

It is useful when evaluating banks and other financial institutions that carry a number of assets on their balance sheets. 

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How growth investors can use variations of the P/E ratio

Growth investors often use the P/E ratio as a building block for finding two other metrics: the forward P/E and the PEG ratios.

  • The forward P/E is calculated by dividing the stock price by the company's expected future earnings. 
  • The PEG ratio is calculated by dividing the company's P/E ratio by its expected earnings growth.

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Why Should You Value Shares?

It is important to understand that the stock's intrinsic value is not necessarily directly tied to its current market price.

The efficient market hypothesis, a theory that states that all known information is currently priced into a stock. However, this is not always the case.

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What's a good P/E ratio to buy a stock at?

Unfortunately, there's no P/E ratio set in stone that makes a stock a buy if it's below, or a sell if it's above.

Often value investors and growth investors will look for different things in a P/E ratio. 

  • Value Investors - the lower the P/E ratio the better.
  • Growth Investors - are much more likely to buy stocks with higher P/E ratios, believing the superior earnings growth more than justifies the higher cost.

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