Investors can attribute a share price to four basic factors – the price-to-book ratio, price-to-earnings ratio, the price-to-earnings-growth ratio, and the dividend yield.
Price-to-Book Ratio
The P/B (price-to-book) ratio represents the value of a company if it were to be taken apart and sold today. This is good to know because while the growth of some mature industries may stall, their assets may still hold value. The book value of a company includes anything that can be sold, including equipment, buildings, land, and other investments. In purely financial companies, the book value can fluctuate with the market as these stocks tend to have assets that go up and down in value. In contrast, industrial companies tend to have a book value based on physical assets, which depreciate year after year according to accounting rules.
In either scenario, a low P/B ratio can protect you, but only if it’s accurate, and an investor may need to investigate the assets contributing to the ratio.
Price-to-Earnings Ratio
The P/E (price-to-earnings) ratio is the most scrutinised of all four ratios. Although a stock’s value can go up without the P/E ratio rising, the P/E ratio is generally what causes it to stay up, or fall back to earlier levels.
The reasoning behind this is simply that a P/E ratio can be thought of as how long a stock will take to pay back your investment if there is no change to the business. For example, a stock trading at $50 per share with earnings of $2 per share has a P/E ratio of 25, meaning you’ll make your money back in 25 years if nothing changes. The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings, which will result in a shorter payoff period.
If this fails to happen, the stock is likely to fall to a more reasonable P/E ratio. If it does manage to increase its earnings, it will probably continue trading at a high P/E ratio.
Investors should note that they should only compare P/E ratios between companies in similar sectors and markets.
Price-to-Earnings-Growth
Many investors also use the PEG (price-to-earnings-growth) ratio, as this incorporates the historical growth rate of a company’s earnings and can assist investors in forecasting future growth. The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-on-year growth rate of its earnings. The lower the value of the PEG ratio, the better deal you’re getting for the stock’s future estimated earnings.
By comparing two stocks using the PEG (in the same sector) ratio, you can see how much you’re paying for growth in each case. A PEG of 1 means you’re breaking even if growth continues as it has in the past. A PEG of 2 means that you’re paying twice as much for projected growth than you paid for a stock with a PEG of 1. However, using the PEG ratio to predict future growth is speculative, as there are no guarantees that growth will continue as it did in the past.
Dividend Yield
Dividend-paying stocks are attractive to many investors, as even when share prices fall you still get paid (perhaps not as much as when the share price was higher, but it’s better than nothing). The dividend yield is the annual dividends per share divided by the share price, so tells you your return on your investment. For example, if a company’s shares are trading at $20 and they pay a dividend of $1 per share, that is a 5% return on your investment ($1/$20 = 5%).
Inconsistent dividends or suspended payments in the past could mean that the future dividend yield isn’t dependable. Also, dividends can vary by sector, with some industries being quite generous while others reinvest their earnings to fuel expansion.
Conclusion
Each factor has too narrow a focus to be an independent measure of a stock. However, combining these methods of valuation can help investors better evaluate a stock’s value. Although any one of these can be influenced by creative accounting, the more tools you add to your valuation methods, the easier it will be to pinpoint discrepancies.
