Valuation Tools for Stocks

In Bull Market when stocks are doing good, investors think the happy days will last forever, and they are willing to pay exorbitant amounts for earnings. In Bear Market When stocks prices comes down drastically, they assume the world is ending and refuse to pay much of anything. In assessing how much a stock is worth, investors talk about “valuation,” the stock price relative to any number of criteria. The P/E, for example, compares a company’s stock price to its earnings.

Price/earnings (P/E) ratio: Everybody uses it, but not everybody understands it. The actual P/E calculation is easy: Just divide the current price per share by earnings per share. Just about every finance website with a quote box provides the P/E — including money.com. But what number should you use for earnings per share? The sum of the past four quarters? Estimates for next year?

There is no right answer. The P/E based on the past four quarters provides the most accurate reflection of the current valuation, because those earnings have already been booked. But investors are always looking ahead, so most also pay attention to estimates, which also are widely available at financial websites.

The P/E can’t tell you whether to buy or sell — it is merely a gauge to tell you whether a stock is overvalued or undervalued. Is a Rs100 stock more expensive than a Rs50 stock? Maybe not. Geometric, for example, is trading at Rs 500 and is expected to earn nearly Rs 27-28 a share in 2005 — a P/E of 17. HFCL, meanwhile, was trading for just Rs17 but it was slated to earn little less than Rs1 per share or even -ve in 2005, for a P/E of around? So Geometric, selling for more than 30 times the price of HFCL, is actually the cheaper stock, though not, necessarily, the better buy.

What’s an appropriate P/E? Different types of stocks win different valuations. Generally, the market pays up for growth.

To quickly compare P/Es and growth rates, use the PEG ratio — the P/E, based on estimates for the current year, divided by the long-term growth rate

PEG= PE/Growth estimate %

In general, you want a stock with a PEG that’s close to 1.0, which means it is trading in line with its growth rate, but for a quality company, you can pay more.

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Tagged as: Earnings, investor, P/E, Valuation