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In this FAQ we’re going to walk through how to value a stock so you know what you’re buying.
0:16 - How to value a stock
0:26 - P/E ratio
1:56 - Price to sales ratio
3:36 - PEG ratio
One of the most common approaches to valuing a company is the P/E Ratio.
This measures a company’s current value against how much it actually earns in income. You can calculate it two different ways, by:
- Taking the company’s market cap and dividing it by net income – OR
- Dividing a company’s current stock price by earnings per share
You’ll wind up with the same number either way because in the share price approach, both numbers have already been divided by the total number of shares the company has outstanding. So it’s two different ways to the same place.
Now you’ll usually see the p/e ratio quoted two different ways:
Trailing twelve month (TTM) – which looks at the company’s actual income over the past twelve months.
Forward – This approach takes analyst estimates of earnings expectations for the upcoming year and using that as the earnings figure.
If a company is growing, its forward p/e ratio will always be smaller than its trailing twelve month p/e ratio, because more income is expected and the denominator will be larger.
If you see a p/e ratio out in the wild and it isn’t specified which kind it is, you can probably assume it’s based on the company’s trailing twelve month earnings.
The P/E ratio only works if there’s an E – or earnings.
So it’s a helpful tool for companies that have income, but it’s totally useless if a company isn’t currently profitable. That’s why investors also use another tool
For unprofitable companies, the p/e ratio would return a negative number, which really wouldn’t be very helpful, so instead investors use the price to sales ratio.
This is a company’s market cap divided by its total sales over the past twelve months. High growth software companies can have price-to-sales ratios of over 10, while more established businesses are usually in the mid to low single digits.
The P/E and P/S ratios are great because they allow you to normalize companies of different sizes and immediately get a sense of what investors are willing to pay for a piece of that company's earnings or revenue. You can use these ratios to compare how a company stacks up to the overall stock market, peers in their industry, or itself relative to the past.
Generally, businesses that are posting high growth rates are going to have higher price-to-earnings and price-to-sales ratios. That’s because investors expect that company to be considerably bigger in the future, and they have bid up shares to reflect that.
That doesn’t mean that they’re bad stocks to own, it just means that people are expecting big growth to continue and if it doesn’t, shares could fall dramatically.
Conversely, stodgy old businesses in crawling industries tend to have lower p/e ratios because they aren’t growing very quickly – for them this year’s earnings will probably look a lot like last year’s earnings. The market isn’t expecting much from stocks with low valuations, so if the outlook gets worse, they’re less likely to take a huge hit, but they’re also less likely to give investors huge returns.
By now you’ve probably realized that these aren’t very complicated calculations to do. Valuation sounds scary to new investors, but really all you’re trying to do with these numbers is get a sense of how much you have to pay for a dollar of earnings or revenue from a company, and what the market expects of that company.
There’s one more easy valuation metric you look at to see how a company’s valuation compares to the growth the company is posting.
The PEG ratio takes the value from the company’s PE ratio, and then compares it to the company’s earnings per share growth rate.
So to calculate it, you first find the P/E ratio for a company, then divide it by the year-over-year earnings growth rate.
The generally accepted rule is that a PEG ratio of 1 represents a “fair value” while anything under 1 is cheap and anything over 1 is expensive compared to the growth the company is posted.
For all these ratios there aren’t absolutes, just guidelines. As investors we’re looking for quality companies with good business models and exciting growth prospects -- it’s worth paying a premium for companies like that, these metrics help us understand what the premium looks like and how it fits into the company’s growth story.
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