The most common method of valuating stocks is based on corporate earnings. Most people look at how much a company earns per outstanding share of stock as a net profit, the amount earned after all bills are paid. To make this easier to understand, we are going to show a highly simplified example.
The earnings per share is a simple calculation that is arrived at by dividing the earnings of a company in rupees by the number of outstanding shares of stock. For example, ABC Corporation reports earnings of 1 million rupees for the year. There are a million shares of stock outstanding. 1 million rupees divided by 1 million shares equals an EPS of 1 rupee per share. This is called a trailing EPS because the calculation is based on reported numbers for the previous year. To make a more pertinent evaluation of a company’s worth, it is important to look at stock valuation – price earning ratio.
What is Price Earning Ratio?
The typical investor uses the price earning ratio (P/E ratio) to determine if a stock is worth its price. This ratio is calculated using the current stock price and looking at its earnings for the last year. An example would be ABC corporation stock price selling at 15 rupees per share. The calculation would be as follows:
15 rupees (share price) divided by the EPS of 1 rupee equals 15 P/E.
In general, it is considered that a higher P/E ratio is a good indicator of the investor’s positive attitude on a given company. However, there are other considerations that must be taken into account.
Are Low P/E Stocks Really Worth it to Buy?
In general, stocks with a low P/E ratio are not a always good buy. People may think stocks with low P/E Ratio are undervalued but there are some exceptions, based on changes taking place in the company, but the fact of the matter is that companies with low P/E ratios are generally in some sort of trouble. This could include a gloomy outlook for the future of the company or industry, a bad reputation, or a history of poor management. Because the P/E ratio is based on numbers already reported, it is possible that changes within the company can improve the value of the stock over time, but the present conditions tend to make this a poor value.
P/E and Growth Ratio and the Year-Ahead P/E and Growth Ratio (PEG and YPEG)
The P/E ratio is often used in an additional calculation to determine if a stock is a good buy. The PEG is a calculation that considers the expected growth of a company along with the P/E ratio. Because a growing company is reasonably expected to grow in value, the P/E and Growth ratio is a valuable consideration. This calculation is achieved by looking at the P/E and projected growth of the company. For example, ABC Corporation has a P/E of 10 and is expected to grow at a rate of 10 percent over the next two years. This calculation would be 10 (trailing P/E) divided by 10 percent growth in EPS equals PEG of 1.
Companies are valued low if they have a lower PEG ratio or high if their PEG is higher. The YPEG is calculated in the same manner, but it looks at expected earnings for the year ahead rather than the trailing P/E. These numbers can be attained from a number of sources online, including the corporations on financial reports and projections.
Understanding stock valuation – price earning ratio is an important first step in making wise investment decisions. Past performance can be a valuable asset in determining the value of a stock, but projected growth is at least as important, if not more so in the long run.