How do we determine what is a “good” stock? What is the best way to value a stock?
The first thing that we must do before we buy a stock is usually determining which stock is worthy to buy. In the stock market, investors separate the stock value into four quantitative variables so that it is easier for us to determine. These variables can help you determine the valuation of a company.
If you are looking to buy a stock, learn these four elements:
1. The Price-To-Book ratio (P/B) / Price-Equity ratio
The purpose of this ratio is to identify the value of a company if it were sold today. In this fast-growing age, many companies are not developing as fast as others in the same industry. However, they may have good value based on their assets. In other words, these companies possess reliable assets such as their real estate, buildings, equipment, and other things that can be converted to cash.
Now you may ask, how do we calculate the P/B ratio?
P/B Ratio= Book value per share/ Market Price per Share
In general, a stock that has a low P/B ratio is considered a safe stock. Many investors discovered that any value under 1.0 is considered a good value for a stock, which also indicates that this is a potentially undervalued stock.
2. The Price-To-Earning ratio (P/E)
The price-to-earnings ratio (P/E ratio) is the ratio of the stock price divided by the company’s annual earnings. In other words, the P/E ratio indicates how much an investor needs to spend in order to pay back one dollar earning.
P/E Ratio= Earning per share/ Market value per share
This price-to-earnings ratio is the most widely-used ratio by investors to analyze stock values. To determine the stock values, many investors compare its P/E ratio with other competitors in the same industry or a benchmark like the S&P 500 Index.
For instance, trading $20 per share with earnings of $2 per share, the investor would get 10 P/E ratio which means that he will need to wait 10 years to earn money back if other values don’t change. Investors would like to buy low P/E ratio stock since a low P/E ratio indicates that the company is doing extremely well in the past few years.
3. Price/Earnings to Growth Ratio (PEG ratio)
The PEG ratio represents a better valuation than the P/E ratio by adding in expected earnings growth into the calculation. The PEG ratio gives a broader picture of the stock’s value and a company’s expected earnings growth.
PEG Ratio= EPS growth*EPS/ Price
EPS = earnings per share
Investors often compare two companies’ PEG ratio to determine the valuation of the company. Investors would like to buy a stock from company A that has a PEG ratio of 1 rather than a stock from company B that has a PEG ratio of 2 because you are paying twice as much for projected growth if investing in company B than company A.
4. Dividend Yield
Dividend yield tells you how much income you receive in proportion to the price of the stock, which is calculated by dividing the stock's annual dividend by the stock's price.
Dividend yield= Annual Dividend/Share Price
Many investors look at the dividend yield to see how much money they can get back if the price drops. The higher the dividend yield, the more money you are likely to get paid.
For instance, a company that has an annual dividend of 0.77 and a share price of 208 would get a dividend yield of 3%. If the company began underperforming for the past 3 years, and the stock's price fell as earnings declined, and they get a dividend yield of 5%, then that would indicate that investors are benefiting from the high dividend yield.
Original Link: https://www.investopedia.com/articles/fundamental-analysis/09/elements-stock-value.asp
Written and Researched by Jessica Guo