A Beginner’s Guide to Stock Valuation
By Max Grinold
When valuing a stock, the price alone cannot tell you the full story. The main focus in simpler valuation methods is understanding: what is the price relative to? You also need to peel back the layers of the company and understand how efficiently they are operating, how profitable they are, and how well they are using their resources to generate returns. This is where key financial ratios like the Price/Earnings Ratio (P/E), Price/Earnings-to-Growth Ratio (PEG), Return on Equity (ROE), and Free Cash Flow Yield come into play. These ratios provide a deeper insight into the company’s financial health, growth prospects, and overall value, helping you make a more informed investment decision.
Price / Earnings Ratio (P/E)
The P/E ratio is found by dividing a company’s share price by its earnings per share. This tells us how much you are paying for $1 of earnings per share. For example: if the share price is $120 and the earnings per share is $12, your P/E ratio would be 10.0x, meaning that you are spending $10 for every $1 of earnings. P/E ratios vary widely from company to company and industry to industry. While some P/E ratios may be high, the company may be projected to rapidly grow their earnings in coming years. This tool can be used to compare similar companies within an industry, to see which ones may be over or underpriced.
Price / Earnings-to-Growth Ratio (PEG)
The PEG ratio is derived by dividing the P/E ratio by the growth rate in earnings per share. This adjusts the P/E ratio by incorporating expected earnings growth. A PEG of 1.0 suggests that the stock is priced in line with its current earnings and expected future growth. Above this threshold may indicate that the stock is overvalued and below is undervalued.
Return on Equity (ROE)
A company’s ROE is found by dividing its net income by the shareholders equity balance (money invested by shareholders). This metric is useful in showing how efficiently a company uses its equity capital, in other words, how much profit they can generate with the money invested by shareholders. It’s important to benchmark ROE against similar companies, as each industry has different margins and capital needs. It should not be used as a standalone metric, but if a company has a high and stable ROE compared to its competitors, it can serve as a strong indicator of capital efficiency.
Free Cash Flow Yield
The free cash flow yield is found by dividing a company’s free cash flow per share by its share price. This metric shows how much free cash flow (cash on hand for the company to distribute to debt and equity holders) a company generates relative to its share price. A higher free cash flow yield in comparison to competitors may indicate that a company is undervalued.
Sources:
https://www.investopedia.com/articles/fundamental/03/100103.asp
https://www.investopedia.com/terms/f/freecashflowyield.asp#:~:text=What%20Is%20Free%20Cash%20Flow,by%20the%20current%20share%20price.
