Investing Basics: How to Value a Stock

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Before we start, I have to warn you that despite my best efforts this may not be the most scintillating post you ever read. If you have watched The Wolf of Wall Street once and decided you want to start cashin’ checks and breakin’ necks in the stock market I’m afraid I have some bad news. Successful investing involves a lot of the boring stuff – like research. You may have decided to get into investing because you have seen people on social media claiming to be getting rich trading crypto’s or forex. Personally, I wouldn’t trust them as far as I could throw them. Yes, some people have made money in Bitcoin and other crypto’s but I’m of the opinion that the party is over.

If you are ready to get stuck into the not so sexy stuff and learn some useful lessons then you may well have a chance of making good returns. Firstly, if you are going to start making individual stock picks then it’s vital you know how to value the stock. There’s a huge amount to consider when valuing a stock but the most basic metric used is the Price to Earnings (P/E) ratio. The P/E ratio gives you a snapshot of the current market price compared to what the company earns in profit.

The P/E is calculated by dividing the share price by the earnings per share (EPS).

The earnings per share is simply the amount of company profit each share earns (total company profit divided by total number of shares).

If you multiply the current share price by the number of outstanding shares you also get the market capitalisation (overall market value of the company).

I told you it was exciting stuff!

Below are two basic examples of P/E calculation. I decided to go for rather exotic company names.

Company A

Share price = £2

Number of shares = 1 million

Market cap  = £2 million 

Earnings (profit) = £200,000

P/E = 10

EPS = £0.20

Company B

Share price = £4

Number of shares = 1 million

Market cap = £4 million

Earnings = £200,000

P/E = 20

EPS = £0.20

What this shows us is that to invest in Company A at the current time you would have to pay 10 times what the company earns for each share. For Company B, you would have to pay 20 times what each share earns. At a glance it would appear that Company B is twice as expensive as Company A, despite having the same earnings. Naturally, Company A would look like the better value stock pick but this version of the P/E doesn’t show the full picture. 

Currently we only have the P/E for the last 12 months, also known as the Trailing P/E. The next part is to figure out what the future of each company looks like. For example, the earnings of Company A may not be growing at the same rate they used to, whereas Company B could have strong growth forecast for the future. When we want to place a value on the future earnings of a company we have to calculate the Forward P/E (i.e. the next 12 months). In the example below I have applied a 20% growth rate to the earnings of Company B but only a 3% growth rate to Company A.

Company A

Share price = £2

Number of shares = 1 million

Market cap = £2 million

Forecast earnings for next 12 months = £206,000

Forward P/E = 9.7

Company B

Share price = £4

Number of shares = 1 million

Market cap = £4 million

Forecast earnings or next 12 months = £240,000

Forward P/E = 16

Already the difference in price is becoming narrower. The P/E for Company B has fallen from 20 to 16, whereas the P/E for Company A has only fallen from 10 to 9.7.

Now let’s look at an alternative scenario, where the earnings for Company A are forecast to decline. This would cause the forward P/E to increase, making the company more expensive.

Company A

Current day share price = £2

Number of shares = 1 million

Market cap = £2 million

Forecast earnings for next 12 months = £150,000

Forward P/E = 13.3

With the earnings of Company A falling and Company B increasing, we now have forward P/E of 13.3 and 16 respectively. Much closer than the original 10 and 20 we obtained from the trailing P/E. Furthermore, Company B is growing at a rapid rate, whereas Company A is in decline. With this new information Company B is starting to look much more appealing.

For those new to investing I would expect your next question would be what is the ideal number for the P/E to be at for you to invest. This is not a simple question to answer and I would suggest you do a lot more research on valuations before you start investing (be sure to check out the resources page of the website). As you have seen in the examples above, the future earnings of the company can make a big difference to the value. A lot will also depend on which stage the company is at in terms of growth and how strong the brand is. If the P/E was the same for both companies would you rather buy shares in Apple or Nokia?…

For an established company making consistent returns then a P/E of around 10 is a good benchmark for a value pick. However, if you are looking to invest in a company which is growing rapidly then you will most likely have to pay a lot more than 10 times earnings. In order to know where to start you should learn more about the different types of investing (value, growth, momentum etc) and decide which suits you best. You can then use a market screener to filter out the companies which fall outside your desired value range. A good starting point when looking for value picks is to set the P/E range from 5 to 12.

Summary

The price to earnings ratio is great at giving a snapshot of a company’s market value. However, there are many other things to consider so you should not focus on the P/E ratio alone. What does the future of the company look like? Does the company have a lot of debt? How well is the company run and what kind of competition do they have? These are just a few of the questions you need to be asking when deciding whether or not to invest in a company. The answers to these questions will have just as much impact on your returns as the price you pay for the stock.


Thinking of investing in the stock market? Be sure to check out Warren Buffet’s number one rule. 

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