Your comprehensive guide to stock valuations based on earnings
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
As you are no doubt aware, one of the most significant drivers of stock market prices corporate earnings. If the market expects the earnings of a company to grow significantly, this expectation will result in higher stock prices. To allow for proper comparisons (apples to apples rather than apples to oranges) between different companies, one of the most commonly used methods is to calculate the Earnings per Share (EPS). This ratio enables like to like comparisons of the performance of two different companies because it relates the earnings to the net worth and provides an indication of undervaluation or overvaluation.
The ratio is easily calculated by taking the earnings of the company and dividing it by the number of shares outstanding. If a company has 10 million shares outstanding and its earnings are $20 million, the EPS is $2. If you use the data for the last four quarters, it is called a “trailing” EPS. The EPS itself provides you with very little information on which to base an investment decision… Investors therefore use the EPS to establish what is called a Price/Earnings ratio (P/E. ratio) which is the current market price of the stock divided by EPS. To continue with the above example, if the share price is currently $10, the EPS of $2 would translate into a P/E. ratio of 10. This ratio is commonly known as a multiple because it establishes the earning multiple at which investors would be prepared to buy the stock.
Unfortunately, many investors believe that once they have established a P/E. ratio that is the be all and end all of their analysis. Without attempting to do anything else, they make their investment decision on this basis alone. It is true that this ratio was extensively used by the father of value investing, Benjamin Graham, but he also used other techniques and ratios to value stocks. If you are lazy enough to believe that that the P/E. ratio is a magic bullet and no other work needs to be done, think again. Value investing consists of much more than just trying to spot stocks that have a low P/E. ratio. As a rule of thumb, many investors believe that the P/E. ratio should match the EPS growth to indicate a fair valuation.
In the times of Benjamin Graham, there were no computerized quotations available and investors had to wade through pages of stock tables to pinpoint companies with low P/E. ratios. Nowadays, a push of a button on your computer will give you a list of such companies. This significantly reduces the chances of mispricing because every investor has access to the same data. You should also remember that can investors do not make decisions on the basis of historical data but on their expectation of future growth. You can create a short list of companies with low P/E. ratios but you will need to supplement your homework by using other valuation techniques to determine that the company is suitable for investment. It is true that you may be lucky enough to find companies that the market has overlooked but you will need to confirm the future prospects.
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