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Understanding the P/E and Other Valuation Ratios
by Dave 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
November, 2007
Valuation means assigning a ''proper'' or "fair" value to a stock. That is
important, because it becomes a guide to what is an advantageous 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.
There are two ways to value a stock:
(1) Net present value method. Many large-scale institutional investors and
advisers—mutual funds, brokerages, hedge funds—have developed complex
mathematical models for determining a stock’s ''proper'' price. Virtually all of
them involve computations of the "net present value" of the stock, based on
many inputs: past earnings and cash flows, projected future earnings and cash
flows, interest rates, projections of sales growth (or decline), and so on. Valuing
stocks this way is beyond the ability of the average individual investor.
(2) Valuation ratios. Fortunately, this second method is just as good, easy to
understand, and readily accessible to the individual investor.
Valuation ratios divide the stock’s current price (P) by some other number
describing its business: earnings, revenue, 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. Valuation ratios can be found, for free, at virtually any financial
Web site.
Here are some common valuation ratios that the Sensible Stock Investor 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. The historical long-term average P/E ratio is about 17-18. A really good
one would be in the low teens or single digits. A really bad one would be over
80 or 100.
-- P/S, or price-to-sales ratio, which compares the stock’s price to the company’
s revenue. The historical long-term average P/S ratio is about 3.3. A good one is
anything under 2. A bad one is anything over 6.
-- 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). An
average P/B ratio is about 5-6. A good one would be below 4. A bad one would
be above 7.
-- PEG, which is the P/E ratio divided by the earnings growth rate of the
company. Historically, the average PEG ratio is about 1.7. Anything 1.0 or
below is considered good. 2.1 or above is considered poor.
The Sensible Stock Investor uses several valuation ratios to judge the price of a
stock, not just one. It is easy to look them up. On most financial Web sites,
they are precomputed and current to the very day.
The idea is to find stocks that the market is undervaluing for some reason. So if
several or all of the valuation ratios for a stock are "good," that suggests that the
stock is selling for a bargain price. If the company is an excellent one, you may
want to buy such a stock. On the other hand, even if the company is excellent,
if its valuation ratios are poor compared to historical averages, its current price
is probably too high. That makes it less likely that its stock price will rise; it is
more likely to go sideways or down. So the wise investor usually stays away
from such stocks.
Sensible Stock Investing supplies Easy-Rate scoresheets for tallying valuation
ratios and deciding whether a stock is a good buy at its current price. These
scoresheets are but one of many tools in the book to make stock investing easier
(and more successful) for the individual.
by Dave 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
November, 2007
Valuation means assigning a ''proper'' or "fair" value to a stock. That is
important, because it becomes a guide to what is an advantageous 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.
There are two ways to value a stock:
(1) Net present value method. Many large-scale institutional investors and
advisers—mutual funds, brokerages, hedge funds—have developed complex
mathematical models for determining a stock’s ''proper'' price. Virtually all of
them involve computations of the "net present value" of the stock, based on
many inputs: past earnings and cash flows, projected future earnings and cash
flows, interest rates, projections of sales growth (or decline), and so on. Valuing
stocks this way is beyond the ability of the average individual investor.
(2) Valuation ratios. Fortunately, this second method is just as good, easy to
understand, and readily accessible to the individual investor.
Valuation ratios divide the stock’s current price (P) by some other number
describing its business: earnings, revenue, 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. Valuation ratios can be found, for free, at virtually any financial
Web site.
Here are some common valuation ratios that the Sensible Stock Investor 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. The historical long-term average P/E ratio is about 17-18. A really good
one would be in the low teens or single digits. A really bad one would be over
80 or 100.
-- P/S, or price-to-sales ratio, which compares the stock’s price to the company’
s revenue. The historical long-term average P/S ratio is about 3.3. A good one is
anything under 2. A bad one is anything over 6.
-- 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). An
average P/B ratio is about 5-6. A good one would be below 4. A bad one would
be above 7.
-- PEG, which is the P/E ratio divided by the earnings growth rate of the
company. Historically, the average PEG ratio is about 1.7. Anything 1.0 or
below is considered good. 2.1 or above is considered poor.
The Sensible Stock Investor uses several valuation ratios to judge the price of a
stock, not just one. It is easy to look them up. On most financial Web sites,
they are precomputed and current to the very day.
The idea is to find stocks that the market is undervaluing for some reason. So if
several or all of the valuation ratios for a stock are "good," that suggests that the
stock is selling for a bargain price. If the company is an excellent one, you may
want to buy such a stock. On the other hand, even if the company is excellent,
if its valuation ratios are poor compared to historical averages, its current price
is probably too high. That makes it less likely that its stock price will rise; it is
more likely to go sideways or down. So the wise investor usually stays away
from such stocks.
Sensible Stock Investing supplies Easy-Rate scoresheets for tallying valuation
ratios and deciding whether a stock is a good buy at its current price. These
scoresheets are but one of many tools in the book to make stock investing easier
(and more successful) for the individual.
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