Decode Earnings with 12 Infographics
01 Four Common Methods for Valuing a Stock
Fundamental investors generally base their investment decisions on the intrinsic value of a stock. They tend to believe that when investing in a stock that is perceived to be undervalued, they are more likely to make a potential profit. Conversely, they believe that buying an 'overvalued' stock poses a higher risk of loss. The company's earnings report can provide insight into a stock's value, and fundamental investors commonly consider the following four methods.
1. PE Ratio
The PE ratio measures a company's stock price relative to its earnings per share (EPS). EPS is calculated by dividing a company's net income by the number of outstanding shares of its common stock. It can also be calculated by dividing a company's market cap by its net income.
The PE ratio is a widely used financial metric to measure the valuation of companies with stable earnings. Some market participants believe that a PE ratio below 20x may be reasonable for companies with annual growth rates below 10%. It's also important to compare a company's PE ratio with its competitors. If its PE ratio is well below the industry average, it might be undervalued. However, leading companies within an industry may trade at a premium.
2. PB Ratio
The PB ratio measures a company's stock price relative to its book value per share. The ratio can be calculated by dividing a company's market capitalization by its book value.
The ratio is generally used to evaluate cyclical stocks. Typically, a PB ratio below 1 may be considered reasonable. In some cases, companies with high levels of liabilities may need an even lower PB ratio to be considered reasonable, in order to account for the additional risk.
3. PS Ratio
The PS ratio measures a company's stock price relative to its revenue per share. The ratio can be calculated by dividing a company's market capitalization by its gross revenue.
The PS ratio is used to evaluate companies with high growth potential that are not yet profitable. When using this metric, it is important to compare a company's PS ratio to others in the same industry to get a sense of its relative valuation, as different industries may have different levels of typical profitability and revenue growth.
4. PEG Ratio
The PEG ratio measures a company's value by taking into account both its PE ratio and earnings growth rate. It is calculated by dividing a company's PE ratio by its expected earnings growth rate over a certain period.
This ratio is often used to evaluate companies with high growth rates, as these companies may have high PE ratios that could be brought down over time as their earnings continue to grow. A PEG ratio below 1 is generally considered undervalued.