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How to Value Stocks Using Valuation Ratios
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
July, 2006
Valuation means assigning a “proper” value, or price, to a stock. The quote
marks around “proper” remind us that while the word implies that there is a
single “correct” price, in fact the concept is theoretical. Valuation is nevertheless
an important guide to what price at which to buy or sell a stock. If you pay too
much for a stock—more than it is “worth”—your returns will suffer forever
after.
Many large-scale institutional investors—mutual funds, brokerages, hedge
funds—have developed complex mathematical models for determining a stock’s
“proper” price. The individual investor needs to go a different route.
Fortunately, a second method exists which is just as good, easy to understand,
and readily available. This second method uses “valuation ratios.”
Valuation ratios divide the stock’s current price (P) by quantifiable aspects of its
business: its earnings, its revenue, its book value, and so on. Each ratio is then
compared to historical norms to tell whether the stock is fairly priced at its
current price P.
Here are some common valuation ratios that Sensible Stock Investing uses:
· P/E, or price-to-earnings ratio. This compares the stock’s price to the
company’s reported earnings. This is the famous “multiple” that one often hears
about.
· P/S, or price-to-sales ratio, which compares the stock’s price to the
company’s revenue.
· P/B, or price-to-book ratio, which compares the stock’s price to the
company’s book value (as computed by accepted accounting principles).
· PEG, which is the P/E ratio divided by the earnings growth rate of the
company.
· P/CF, or price-to-cashflow, which compares the stock’s price to its
annual flow of cash.
Happily, all of these valuation ratios, plus others, are available for free on
virtually all financial Web sites. They are usually current to the very day. If you
know the historical benchmarks, it is easy to interpret each ratio as indicating
whether, like Goldilocks’ porridge, a stock’s price is too hot, too cold, or just
about right.
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
July, 2006
Valuation means assigning a “proper” value, or price, to a stock. The quote
marks around “proper” remind us that while the word implies that there is a
single “correct” price, in fact the concept is theoretical. Valuation is nevertheless
an important guide to what price at which to buy or sell a stock. If you pay too
much for a stock—more than it is “worth”—your returns will suffer forever
after.
Many large-scale institutional investors—mutual funds, brokerages, hedge
funds—have developed complex mathematical models for determining a stock’s
“proper” price. The individual investor needs to go a different route.
Fortunately, a second method exists which is just as good, easy to understand,
and readily available. This second method uses “valuation ratios.”
Valuation ratios divide the stock’s current price (P) by quantifiable aspects of its
business: its earnings, its revenue, its book value, and so on. Each ratio is then
compared to historical norms to tell whether the stock is fairly priced at its
current price P.
Here are some common valuation ratios that Sensible Stock Investing uses:
· P/E, or price-to-earnings ratio. This compares the stock’s price to the
company’s reported earnings. This is the famous “multiple” that one often hears
about.
· P/S, or price-to-sales ratio, which compares the stock’s price to the
company’s revenue.
· P/B, or price-to-book ratio, which compares the stock’s price to the
company’s book value (as computed by accepted accounting principles).
· PEG, which is the P/E ratio divided by the earnings growth rate of the
company.
· P/CF, or price-to-cashflow, which compares the stock’s price to its
annual flow of cash.
Happily, all of these valuation ratios, plus others, are available for free on
virtually all financial Web sites. They are usually current to the very day. If you
know the historical benchmarks, it is easy to interpret each ratio as indicating
whether, like Goldilocks’ porridge, a stock’s price is too hot, too cold, or just
about right.
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