Investing would be much simpler if investors could take all of the information presented to them at face value. Unfortunately, however, there is usually more than meets the eye when it comes to investing, and stock prices are no exception. While a company's stock price is important — determining how much of a security an investor can afford — it alone does not tell a stock's full story. Market value coupled with the amount of profits earned for each individual share is useful in determining whether or not a stock is a good value.
To dig a little deeper into a company's stock price, investors can calculate what's known as a price to earnings (P/E) ratio. This number is a reflection of how inexpensive or pricey a stock is based on current or future earnings growth. The calculation involves dividing the current market value of a stock, or the stock price, by the average earnings per share over the past four quarters. When earnings estimates are available, the trailing EPS can be replaced with projections for future earnings performance.
An appropriate P/E ratio in one sector might not be a relevant level in another, so investors should compare the P/E ratios of one stock to others trading in a similar industry. Also, the value of the broad stock market is illustrated in the P/E ratio of the S&P; 500, an index that represents some of the largest companies in the stock market. By comparing a stock's P/E ratio with that of the S&P; 500, an investor can learn how a stock is perceived relative to the rest of the market.
Investment strategies are based on stock valuations and whether or not investors believe companies will deliver earnings growth. Value investors hunt for stocks that — relative to industry or market comparisons — are inexpensive right now. Investors buy shares in these seemingly undervalued stocks in hopes that — eventually — the stock price will rise to better reflect a company's existing or future profit growth. When investors learn that a company appears undervalued, they could drive the stock price higher by purchasing shares in search of a profit opportunity, according to an article on "The Wall Street Journal" website.
Growth investing is another strategy in which investors attempt to capitalize on companies' prospects for future growth. Unlike value stocks, the market value of growth stocks already recognizes earnings growth as reflected in higher valuations, or P/E ratios. Nonetheless, growth investors are willing to pay more in hopes of seeing stock prices rise further as profits continue to grow. Even growth stocks, however, can become undervalued when the broader markets are under pressure. In this case, investors can uncover buying opportunities in growth companies that are undervalued for reasons unrelated to profits, according to an article on the CNBC website.
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