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How to Value a Stock

By Ken Little

What is a share of stock worth? How long is a piece of string?

The answer to both questions is: "I don't know." How long a piece of string is probably doesn't matter much to you, unless you want to fly a kite.

However, figuring out what a stock is worth is of major importance to investors. Like many questions in investing, there are several answers.

When you buy a stock it is because there is some quality you desire. It could be earnings, dividends, sales, or growth potential. You see an opportunity for stability or growth in these areas and want to relate that to the stock price.

In this article, we are going to look at earnings. Earnings or profits can be related to the stock's price in two ways. The first way relates the stock price to historical earnings and is known as Price/Earnings Ratio or P/E.

The P/E is calculated by taking the stock's current price and dividing it by the trailing 12-month earnings per share. Trailing is a key word since it tells you that we are looking back.

Earnings per share or EPS is calculated by taking the annual earnings and dividing by the number of outstanding shares. For example, if a company had annual profits of $5,000,000 and 10,000,000 shares outstanding the EPS would be: $0.50.

Company ABC is currently is trading for $22 per share. With an EPS of $0.50, the P/E is 44 (22/.5 = 44). A P/E of 44 would be considered high.

What does this tell us? One interpretation is that the market is willing to pay a premium for this stock because investors believe earnings will rise. Another investor looking for a good value stock would pass on ABC. They would look for a stock with a much lower P/E.

Let's dispense with the obvious first: A share of stock is worth what someone is willing to pay for it and the price someone else is willing to accept for it. When those two numbers agree, we have a value.

Of course, there is more to it than that. Both parties have to come to some value that is independent of the other.

Which gets us back to the question. If I am interested in buying ABC stock, how do I know what is a good price or value for the stock?

We are going to look at several ways to value a stock in this series. I don't believe there is any one magic number or ratio that tells the whole story. However, using seveal measures we can build a profile of the stock that will give us a value.

Like there is no one magic number to value a stock, there is no one value of a stock. Two investors with access to the same information will often come to a different value. The important thing is that you come to a price you are willing to pay through an analysis of where the stock is and where you believe it is going.

Definitions
Price Earnings Ratio (P/E) is the price of a stock divided by its EPS.
Earnings Per Share (EPS) is the past 12 month's earnings divided by the outstanding shares.
Forward PEG is the P/E divided by projected EPS growth. The projected EPS growth comes from analysts who follow the stock.
Don't worry about all this math. Almost any online quote service will have these numbers already calculated for you.
Investors might conclude the market had a lot of confidence in ABC's ability to increase earnings. Technology stocks, particularly of young companies, almost always have high P/Es.

How do we know when they are too high? To get a handle on that, we need to look into the future at what we might expect from ABC.

This brings us to the second way we relate stock price to earnings:
 
Forward PEG

The forward PEG tries to look forward at whether there is justification for optimism. You calculate the forward PEG by taking the P/E and dividing it by projected EPS growth. The projected EPS growth comes from analysts who follow the stock.

ABC has a P/E of 44 and analysts feel their EPS will grow by 65% per year. The PEG is then .68. (44/65 = .68)

A PEG of 1 would suggest that the stock's value is on target, since the P/E should approximately equal EPS growth. A PEG under 1 may mean the stock is undervalued.

Based solely on these two calculations, one could conclude that the market is undervaluing ABC's future potential.

Any time you look into the future, you are treading on a slippery slope. If ABC doesn't hit their earnings estimates, the forward PEG is meaningless.

You still don't have enough information to decide whether ABC is a good buy or not, but you know a lot more now than before you started.

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