When buying stocks, the first thing you might look at is the price. However, the stock price and its value are not the same thing. Considering the value of a stock helps determine whether its current price is cheap or expensive. This can assist you in deciding whether it is worth investing in or not.
Why Doesn’t Price Always Indicate Stock Value?
It can be tempting to buy as many shares as possible at the lowest prices and hope that their value rises one day. However, the cheaper stock may not provide the best true value.
A $5 stock may seem like a good deal at first glance. However, if you are dealing with an unstable startup, you may not get the best return on the money you invest. On the other hand, it might be difficult to make a decision to invest in a more expensive stock trading at $150. But if it comes with dividends and a stable history of growth, it may be a safer place to put your money.
The value of a stock is related to more than just the age of the company. There are three data points that can reliably show you the value of a stock beyond its price. These are earnings per share (EPS), price-to-earnings ratio (P/E), and price/earnings to growth ratio (PEG).
How Can You Use Earnings to Determine Stock Value?
Many novice investors believe that the stock price, whether it is “cheap” or “expensive,” is the same as its value. However, treating these two as the same thing can lead to unwise investment decisions.
For example, let’s look at the stocks of two companies: Smith Organic Company and Jones Organic Company. Smith Organic Company’s stock is priced at $10, while Jones Organic Company’s stock is priced at $2000. Which one is cheaper? At first glance, it may seem that Smith’s shares are much cheaper and thus represent better value. But that might not be true. This is due to something called “earnings per share” (EPS). EPS measures the value of the stock based on the company’s net profit and outstanding shares.
Let’s assume that Smith Organic Company has one million shares outstanding, while Jones Organic Company only has 1000 shares outstanding. If both companies are achieving one million dollars in earnings annually, then Jones Organic Company gives you more value for your money. This is because it has a higher earnings per share. Smith Organic Company’s earnings: $1,000,000 / 1,000,000 shares = $1 per share; Jones Organic Company’s earnings: $1,000,000 / 1000 shares = $1000 per share.
Each share of Smith Organic Company is worth one dollar of its profit. However, one share of Jones Organic Company is worth $1000, which is a significantly higher value. Even though one share of Jones Organic Company costs more than one share of Smith Organic Company, it is 100 times more valuable.
However, you should not rely solely on EPS to determine the right stock.
Using the Price-to-Earnings Ratio to Understand Stock Value
Another common option for evaluating stock prices is the price-to-earnings (P/E) ratio. The price-to-earnings ratio provides an indication of how much investors are willing to pay for each unit of earnings. Companies use this metric to assess whether their stock price is lower or higher than it has been in the past. It can also be used to compare stock values between companies.
To find the price-to-earnings ratio, divide the current stock price by the current earnings per share. If a stock has a P/E ratio of 50, then investors are willing to pay $50 for every dollar of earnings.
Typically
what companies want is to have lower price-to-earnings ratios. The lower the ratio, the better the stock seems. However, you should beware of the value trap. This happens when a stock appears cheap due to a low price-to-earnings ratio, but this low ratio indicates weak future earnings prospects. Stocks like these may not be the right investment.
Stocks with low price-to-earnings ratios are cheaper to buy than those with high price-to-earnings ratios. By purchasing these stocks at a lower price, some investors hope that stocks with low price-to-earnings ratios will rebound. If that happens, investors will make a profit.
Here is an example of how to find the price-to-earnings ratio: Smith Organic Company: Stock Price $10 / Earnings per Share $1 = Price-to-Earnings Ratio 10. Jones Organic Company: Stock Price $2000 / Earnings per Share $1000 = Price-to-Earnings Ratio 2.
The stock of Smith Organic Company at $10 is still much cheaper than the stock of Jones Organic Company at $2000. But the stock of Jones has better value because it has a lower price-to-earnings ratio.
Using Price-to-Earnings to Growth Ratio to Understand Stock Value
Price-to-earnings to growth ratio, or PEG, looks similar to the price-to-earnings ratio. However, it examines value in a different way. This ratio can help you determine whether a stock is undervalued or overvalued.
To find the PEG ratio for a stock, divide the price-to-earnings ratio by the growth rate. In some cases, the PEG ratio can provide a clearer picture of a stock’s value than the price-to-earnings ratio. If the value is greater than 1, the stock is overvalued relative to its growth rate. If the value is 1 or less, it is at a balanced or undervalued level compared to the stock’s growth rate.
At the end of the day, the lower the PEG ratio, the better the value generally is. A low ratio means you’ll pay less for each unit of earnings growth you get if you invest in that stock.
Let’s take another look at Smith Organic Company and Jones Organic Company. You can calculate their PEG ratios, assuming a 5% EPS growth rate for both. Smith Organic Company: Price-to-Earnings Ratio 10 / 5% Annual Earnings = PEG Ratio 2. Jones Organic Company: Price-to-Earnings Ratio 2 / 5% Annual Earnings = PEG Ratio 0.4.
It turns out that Jones Organic Company is the more valuable choice, even using this metric. The PEG ratio also delves into a company’s earnings prospects beyond EPS. It can be used to compare stocks of companies in different sectors and industries.
Let’s say a tech stock trades at a price-to-earnings ratio of 20, while the price-to-earnings ratio of a manufacturing company is 15. The latter may seem like a good buy due to its lower price-to-earnings ratio. But given the growth of the tech industry, the tech stock might have a growth rate of 30%. The manufacturing company might only have a growth rate of 10%. The PEG analysis will present a very different picture. PEG ratio for the tech stock: 20 / 30% = 0.67. PEG ratio for the manufacturing stock: 15 / 10% = 1.5.
In this case, the tech stock has a high price-to-earnings ratio. However, it also has a lot of potential for earnings growth. This could mean it’s still a good investment option.
Conclusion
Knowing
The difference between a stock’s price and its value is essential to understanding that stock’s worth. Earnings per share, the price-to-earnings ratio, and the price-to-earnings-to-growth ratio can help illustrate a stock’s value in ways that go beyond just the stock price. The price-to-earnings-to-growth ratio provides an additional perspective, as it uses the price-to-earnings ratio to shed light on growth rates. Ultimately, the method you choose to determine whether a stock is too expensive or a good deal is up to you.
Source: https://www.thebalancemoney.com/what-does-stocks-are-cheap-or-expensive-mean-3140707
Leave a Reply