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Useful Stock Valuation ToolsDetermining If a Stock Is Undervalued or Overvalued
Among the most commonly used tools when determining whether a company is undervalued or overvalued are P/E and PEG ratios.
Calculating the Price-to-Earnings ratio is explained in more detail in Master Price-to-Earnings Ratio, but it cannot hurt to summarize what this particular tool can do for ordinary investors. Price-to-Earnings RatioWhat this ratio is demonstrating is how a company’s market price compares to its earnings per share. Analysts often refer to P/E ratio as the multiple, meaning how many times over investors are willing to pay for each dollar of a company’s earnings. Note that analysts usually rely on EPS numbers from the last four quarters. However, when they want to turn to their “crystal balls” and look into the future, analysts often rely on the next four quarters EPS estimates. In that case, we are talking about a projected or forward P/E. Forward P/E RatioGenerally speaking, the higher the P/E ratio, the higher the expected future earnings. Unfortunately, this simple premise is also the ratio’s worst limitation. For example, when the “dot.com” revolution was still heating up, there were companies that traded at multiples of 10,000 and more over their earnings. Considering how that piece of stock market history unraveled, it does not require a rocket scientist to figure out that P/E ratio might not always be the most accurate tool when evaluating a company. Generally, investors will see high P/E ratios in companies that are still in early development stages and generating little or no revenues. In such instances, a high P/E ratio is not painting an accurate picture about a company’s future prospects. No company can go on forever without revenues. Remaining frozen in time is never an option in any corporate dynamics. So, why Is P/E Ratio Popular with Analysts?P/E ratio is a frequently used tool with analysts because there is important information contained within the formula. When evaluating a company, one of the first things everyone will look at are the earnings. Earnings, after all, are a reflection of a company’s profits. Earnings are a one way to tell whether a business is thriving or contracting, and whether a company is sensible about its resources. But there is more to a company than just its earnings or P/E ratio. Factors such as the quality of a company’s product, the strength of its management, market share, etc. also play a significant role. When combined together, they provide the company’s rate of EPS growth. Many analysts perceive EPS growth rate as a much more relevant tool for determining whether a company is undervalued or overvalued. The PEG RatioThe so-called PEG ratio captures the relationship between the P/E ratio and earnings growth. It also relates a much stronger argument pro or against a company. Finally, the same principle applies to the PEG ratio as it does to the P/E ratio, whereas the higher the PEG, the more valued is a company. This article is part of the series. To read the next installment, please click here.
The copyright of the article Useful Stock Valuation Tools in Shares/Stocks is owned by Inya Ivkovic. Permission to republish Useful Stock Valuation Tools in print or online must be granted by the author in writing.
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