Introduction
to Stock Valuation Methodologies
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How are Stocks Valued?
Ultimately, the value of a stock
is determined by the forces of supply and demand. Investors
are willing to purchase a stock at a price that provides for
a reasonable return on investment and that fairly compensates
them for the risk of stock ownership.
In theory, the market is a perfectly
efficient valuation mechanism where the value of every stock
is perfectly calculated and represented by its price. And
in a world of perfect information that theory would approach
reality. Unfortunately - or fortunately, depending on your
perspective, we live in a world of imperfect information.
Imperfect information in the stock market spells uncertainty.
And uncertainty magnifies risk. Ultimately then, stock valuations
are dependent on a host of different variables and subject
to the collective whims of individual investors. In short,
stock valuation is an imprecise science.
Price / Earnings Ratio
One of the measures that investors
use to judge the value of a stock is the stock's price to
earnings ratio - also known as the P/E ratio. The P/E ratio
tells us how many years it will take us to recoup our initial
investment if the future profits continue at current levels
(all other things remaining equal). For example, if a company
generates $1 of profit for each share of outstanding stock
and the stock is currently selling for $18 per share then
the P/E ratio would be calculated as the price per share ($18)
divided by the earnings per share ($1). This would yield a
P/E ratio of 18. A P/E ratio of 18 suggests that if company
earnings were to remain constant into the future (at $1 per
share), it would take 18 years to recoup your initial $18
investment. Eighteen years is quite a long time to recoup
your initial investment. So why would anyone want to buy stocks?
Well, the reality is that earnings
at most companies do not stay flat - they grow over time.
This is an important concept. Because if company earnings
are growing rapidly from year to year, it will not take 18
years to return the initial investment. This is what investors
are counting on. This is why P/E ratios tend to be higher
for companies that have demonstrated an ability to rapidly
grow revenues and earnings. P/E ratios of 25 to 50 have not
been uncommon for fast growing companies in the most recent
bull market. In the heyday of internet euphoria, P/E ratios
for the hottest dot.coms exceeded 200 - an absurd and ultimately
unsustainable earning multiple. Historically, P/E ratios for
common stocks have averaged around 15. That is to say, that
on average, investors have been willing to pay up to 15 times
current year earnings for a share of stock. It is important
to understand that this is an average. As mentioned earlier,
faster growing companies typically will merit a higher P/E
than companies whose sales and profits are growing more slowly.
Certain cyclical companies, such as auto manufacturers typically
have lower P/E ratios than say, a typical high-tech company.
A high or low P/E ratio is not a sufficient justification
to buy or shy away from a stock. The company's P/E ratio has
to be evaluated in the context of the industry, the economy,
and the forecasted performance of the specific company. Having
said that, be wary of companies with extremely high P/E ratios.
When the market takes a turn for the worse, stocks with lofty
P/E ratios will generally be among the hardest hit. Ultimately
there are only two ways to reduce a high P/E ratio: by dramatically
increasing company earnings, or by reducing the stock price.
If you buy a stock at a peak P/E multiple, don't be surprised
if you're left holding the bag as investors stage a wholesale
retreat when it becomes apparent that the stock is fundamentally
overvalued. Paying 200 times earnings for a stock is equivalent
to lending someone 100 dollars and having them pay you back
at the rate of 50 cents per year - not a very astute investment.
Future Earnings Potential
Remember, as a stockholder, your
share of stock entitles you to a percentage of future company
profits. Just because a company has done well in the past,
does not guarantee that it will continue to operate profitably
into the future. As you begin to evaluate prospective investments
you would be well advised to carefully study future earnings
forecasts published by the company as well as outside analysts.
When purchasing the stock of a company, future direction and
profitability is far more important than past performance
and profitability.
Evaluating
Stock Investments
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