Knowing when the price is right
If you don’t have time to read through the whole article, you can check out our short version below:
A great investment must still come at the right price.
The two common methods to value a stock are the price/earnings ratio and the price/earnings to growth ratio.
One of the most common mistakes newbie investors is the tendency to zoom in on a company’s stock price, and make investment decisions based entirely on that.
What you really should do, is to look at a company as a whole: its business model, scalability and sustainability, core fundamentals, and financials before you even consider its stock price.
And once you’ve found a wonderful company that passes all your criteria, does it automatically make it a great investment? Not necessarily.
Even if you are investing in a wonderful company, you may end up waiting a long time for capital gains if the stock is overpriced.
There are cycles which impact even the stocks of the best run companies. And if the stock was overpriced to begin with, investors might have to wait a long time for the stock to start registering prices gains.
So, you will want to buy sound, undervalued stocks if possible, or at least stocks that are not overvalued.
Well, there are many methods to value a stock. Here are two of the more popular ones that investors use:
1. PRICE/EARNINGS (P/E)
- P/E is probably the most common yardstick of valuation. It measures a stock’s price relative to its profits. The higher the P/E ratio, the more “expensive” the stock.
- P/E = Stock Price ÷ Earnings per Share
If you use P/E as valuation, Company A has a relatively low P/E of 10, while Company B has a relatively high P/E of 25, making Company B much more “expensive”.
All things being equal, Company A is the “cheaper” stock and a “better” investment. (“All other things being equal” refers to the quality of the two stocks being broadly similar.)
But of course, no two companies are ever exactly alike. It is important to study a company as a whole to truly understand its value and growth potential.
In this case, Company B could have a more advanced business model, stronger fundamentals, and healthier financials, making its higher P/E ratio entirely justified.
But in cases where two great companies are largely similar, and one is trading at a significantly lower P/E, you might want to take a closer look because it might just be an undervalued investment opportunity.
It is also best to compare a company’s P/E with its specific industry average to gain a clearer benchmark.
2. PRICE/EARNINGS TO GROWTH (PEG)
For some investors, P/E is too simplistic: a “cheap” company (with low P/E) might have stagnant growth, while an “expensive” company (with high P/E) might be growing steadily year after year.
This is where the price/earnings to growth (PEG) ratio comes in.
- PEG measures a company’s P/E ratio while taking into account its earnings growth. The higher the PEG, the more “expensive” a stock. In general, a PEG ratio of 1 indicates fair value.
- PEG = P/E ÷ Annual EPS growth
If you used PEG as valuation, Company A has a PEG ratio of 1, while company B has a PEG ratio of 0.5.
All things being equal, Company B is cheaper: even though it has a higher P/E of 25, it’s growing its earnings at 50% per annum. Company A, with a P/E of 10, is only growing at 10% per annum.
Again, it is always best to compare a company’s ratios with the industry average to gain a clearer benchmark of what is considered poor or good.
Another thing to note about PEG is that growth is tricky to predict, and future growth rates might not follow historical growth rates.
In any case, always make sure that the company first and foremost has a sound business model, solid fundamentals, and strong financials before you even consider making an investment!
It is also best to compare a company’s P/E with its specific industry average to gain a clearer benchmark.This article, which first appeared on The Fifth Person, is reproduced with edits and permission.
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