Key ratios for stock valuation
Beginner Stock Market Investing, Stock Market Investing Strategies
There are many different ways in which stocks are valued using different ratios. An investor might choose to conduct some form of financial analysis such as the price/earnings ratio which is used to determine whether the stock is overvalued or undervalued. Or he might opt for a value of that is based on supply and demand analysis in other words the balance between what he is prepared to pay to buy a stock and what other investors are expecting to sell their stock. Though the fundamentals of supply and demand drive the stock markets, they are difficult to analyze and even more difficult to predict. It is common sense to understand that there could be more sellers at higher prices and more buyers at lower prices but it is not easy to establish any future trends that may be used as a basis for investing.
If you are using ratios for valuing stocks, here are some of the more common ratios that you can use:
You may have heard the term Earnings Per Share (EPS) but do you know exactly what the ratio means? It is the net income of a company divided by the total number of shares outstanding. This may sound deceptively simple but the reality is more complicated because there are several different types of EPS ratios. For instance, the company may report a GAAP (Generally Accepted Accounting Principles) EPS ratio which means that the accounts have been prepared to in conformity with all the rules and regulations that GAAP prescribes. They can also reported a pro forma EPS ratio where the accounts have been adjusted for some items such as one-time earnings or expenses or non-cash items such as amortization of goodwill. What is important is the quality and sustainability of the earnings and you should be suspicious of any company that manipulates their figures to make their earnings look better.
The other popular valuation method is to use Price/Earnings ratios were (PE ratios). Now that you have learnt what an EPS ratio is, if it is a relatively easy process to calculate a PE ratio… All you have to do is to take the stock price and divided by the EPS. If the share is quoted at $20 and the EPS is $1 per share, the PE ratio is 20. Historical PE ratios are calculated by using the figures for the last four quarters of the previous year. It is also useful to look at the PE ratio over the past few years to determine a range and whether the current ratio than is closer to the high or to the low.
Probably the single most popular ratio is the forward the PE ratio because you are examining the future of the company instead of the past. All stocks are priced on the basis of the market expectations of future earnings and not on the basis of historical earnings. This ratio is calculated by taking the current stock price and dividing it by the EPS estimates for the next few quarters or years. Many analysts recommend using a period of two years of future earnings. It is important to remember that this ratio changes constantly as the earnings expectations change and it is important to recompute the ratio at regular intervals.
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