Six Simple Ways to Value a Stock

stock market (Photo credit: 401(K) 2013)

As glamorous and mysterious as the stock market may appear to be, it helps to be an informed investor. To become an educated and empowered investor, you should learn some common ways to value stocks in your portfolio. I am not suggesting you have to become a novice (but how empowered would you feel to actively join in a conversation with co-workers about investing?). If you believe this is important information, KEEP READING

Investors are always searching for methods to help them determine whether a company is worth investing in. There are many means of stock valuation, some simple, some more complex. 1

Why is stock valuation so important? If the market price of the companys stock is greater than the companys intrinsic value, an investor might choose to stay away. If the market price of the companys stock is less than the companys intrinsic value, the investor may choose to buy the stock.

Here are six key valuation methods and their definitions :

Price-to-Earnings Ratio (P/E)

The price-to-earnings ratio (P/E) is a valuation method used to compare a companys current share price with its per-share earnings. Its formula is calculated by dividing its market value per share by its earnings per share. The P/E is one of the most widely used ratios, and it is used to compare the financial performance of different companies, industries, and markets. The companys forecast P/E (its P/E for the upcoming year) is generally considered more important than its historical P/E.

Price-to-Earnings Growth Ratio (PEG)

The P/E ratio is a snapshot of where a company is, and the PEG ratio is a graph plotting where it has been. The PEG ratio incorporates the historical growth rate of the companys earnings. This ratio also tells you how your stock stacks up against another stock. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings.

Price-to-Book Ratio (P/B)

The price-to-book ratio measures a companys market price in relation to its book value. Its formula is calculated by dividing the companys stock by its book value per share. Book value can be found in the companys balance sheet, usually listed as stockholder equity. It represents the value of a companys total assets subtracted by its total liabilities. The P/B does not consider the actual value of the assets, only the nondepreciated portion of the assets. Like most ratios, its best to compare P/B ratios within industries. For example, tech stocks often trade above book value, while financial stocks often trade below book value.

Price-to-Sales Ratio (P/S)

The price-to-sales ratio helps determine a stocks relative valuation. Its formula is calculated by dividing the companys price per share by its annual net sales per share. Price-to-sales ratio is considered a relative valuation measure because its only useful when its compared with the P/S ratio of other firms. The P/S ratio varies dramatically by industry, so when comparing P/S ratios, make sure the firms are within the same industry.

Return on Equity (ROE)

The ROE is calculated by dividing a companys earnings per share by its book values per share. The ROE is a measure of how well the company is utilizing its assets to make money. Understanding the trend of ROE is important because it indicates whether the company is improving its financial position or not.

Dividend Payout Ratio

This ratio is calculated by dividing the dividends paid by a company by its earnings. The dividend payout ratio can also be calculated as dividends per share divided by earnings per share. A high dividend payout ratio indicates that the company is returning a large percentage of company profits back to the shareholders. A low dividend payout ratio indicates that the company is retaining most of its profits for internal growth.