When you invest in a stock, you buy at the market price. Though the market prices suggest a stock’s value based on the wisdom of the crowds, markets can be erratic, because the market price of a stock can change rapidly and the stock prices of similar companies can be very different. Do your own homework to determine if these prices are sensible by comparing a company’s stock price to fundamental measures of the firm. The market price of a stock can be evaluated as cheap, fair, or rich by comparison with earnings per share, book value per share or sales per share.
Identify the market price of the stock in question. You can find the market price of a stock from the stock exchange in which it is trading or from financial websites such as Google Finance or Yahoo Finance. You also can find stock prices for competing companies, and they are important in making comparisons.
Compute the price/earnings ratio. This is the ratio of the market price per share to the earnings per share for every share held. Earnings per share is usually listed on financial websites and can be calculated by dividing the annual net income by the number of shares outstanding. A P/E ratio that is higher than peer firm P/E ratios implies higher market expectations for earnings growth. On the other hand, a P/E ratio that is lower than peer P/E ratios implies lower expectations for earnings growth.
Compute other price ratios. The price/book ratios and price/sales ratios are commonly used to evaluate the market price of a stock. The book value of equity per share is sometimes listed on financial websites and can be calculated by dividing the total equity value listed on a firm’s balance sheet by the number of shares outstanding. The price/book ratio is computed by dividing the market price of a stock by the book value per share. The price/sales ratio is computed by dividing the market price of a stock by sales per share. Sales per share is calculated by dividing the annual sales listed on a firm’s income statement by the number of shares outstanding. P/B and P/S ratios that are higher than those of their peers indicate high expectations for a company in the future, and low P/B and P/S ratios indicate investor pessimism for a stock.
Consider price multiples and a stock’s future prospects. You can use price multiples to gauge the expectations of market participants. You may find that price multiples are too high for stocks that have poor future growth prospects or that price multiples are too low for stocks that have excellent future growth prospects. Consider underweighting stocks that are trading too high, and consider overweighting stocks that are trading at bargain prices.
- The price-to-earnings ratio cannot be calculated for companies that have a net loss. The price-to-sales and price-to-book value are more useful in evaluating the stock prices of such companies.
- Price-to-earnings ratios can be computed based on projections for next year's earnings. These are called forward price-to-earnings ratios.
- The effectiveness of price as a measure of a company’s well-being greatly depends on the efficiency of the market in which the stock is trading. Stocks are better priced in markets where lots of information about a company is available and the stock trades frequently. Market prices alone cannot conclusively be used to evaluate common stock.
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