When expectations are high, the market anticipates that future profits will continue to increase, and it bids up the stock. When pessimism takes over, the market expects fewer profits in the future, and the stock price falls. Ultimately, estimating what a company will do in the future is the key to all forms of stock valuation.
There are two broad approaches to stock valuation. One is the ratio-based approach and the other is the intrinsic value approach. Here's a brief overview to get you oriented. Valuation ratios compare the company's market value with some financial aspect of its performance — earnings, sales, book value, cash flow, and so on.
The ratio-based approach is the most commonly used method for valuing stocks, because ratios are easy to calculate and readily available. The downside is that making sense of valuation ratios requires quite a bit of context.
The other major approach to valuation tries to estimate what a stock should intrinsically be worth. A stock's intrinsic value is based on projecting the company's future cash flows along with other factors. You can compare this intrinsic or fair value with a stock's market price to determine whether the stock looks underpriced, fairly valued, or overpriced.
The advantage of this approach is that the result is easy to understand and does not require as much context as valuation ratios. However, the main disadvantage is that estimating future cash flows and coming up with a fair value estimate requires a lot of time and effort.
The advantages outweigh the disadvantages when this type of valuation is done carefully. Finding great companies is only half the equation in picking stocks.
Figuring out an appropriate price to pay is just as important to your investment success. A great company might not be a great investment if its stock is too expensive.
Likewise, a company of mediocre quality could be a good investment if bought cheaply enough. This content was created in partnership with the Financial Fitness Group , a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
Read more information and tips in our Explainers section. Read more personal finance information, news, and tips on Cashay. Follow Cashay on Instagram , Twitter , and Facebook. Investing Explainers. On one end of the spectrum, active investors -- those who believe they can develop and execute investing strategies that outperform the broader market -- value stocks based on the belief that a stock's intrinsic value is wholly separate from its market price.
Active investors calculate a series of metrics to estimate a stock's intrinsic value and then compare that value to the stock's current market price.
Passive investors subscribe to the efficient market hypothesis, which posits that a stock's market price is always equal to its intrinsic value. Passive investors believe that all known information is already priced into a stock and, therefore, its price accurately reflects its value.
Most adherents to the efficient market hypothesis suggest simply investing in an index fund or exchange-traded fund ETF , rather than taking on the seemingly impossible task of outsmarting the market. For its fiscal year, which ended on Jan. A company's GAAP earnings are the amount of profit it generates on an unadjusted basis, meaning without regard for one-off or unusual events such as business unit purchases or tax incentives received.
A stock for which the valuation implied by the market is substantially below its intrinsic value is likely attractive to value investors. Projected EPS numbers are provided by financial analysts and sometimes by the companies themselves.
The PEG ratio accounts for the rate at which a company's earnings are growing. While most investors use a company's projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections for shorter periods of time increases the reliability of the resulting PEG ratio.
Continuing with our Walmart example, analysts forecast average annual EPS growth over the next five years of 6. A stock with a PEG ratio below 1. Several metrics can be used to estimate the value of a stock or a company, with some metrics more appropriate than others for certain types of companies.
Companies in industries with low profit margins typically need to generate high volumes of sales. Another useful metric for valuing a stock or company is the price-to-book ratio. Price is the company's stock price and book refers to the company's book value per share. A company's book value is equal to its assets minus its liabilities asset and liability numbers are found on companies' balance sheets.
A company's book value per share is simply equal to the company's book value divided by the number of outstanding shares. The lower the value of your PEG ratio, the better the deal you're getting for the stock's future estimated earnings.
By comparing two stocks using the PEG, 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. This is speculative because there is no guarantee that growth will continue as it has in the past.
Armed with this information, an investor has to decide whether it is likely to continue in that direction. It's always nice to have a backup when a stock's growth falters.
This is why dividend-paying stocks are attractive to many investors—even when prices drop, you get a paycheck. The dividend yield shows how much of a payday you're getting for your money. By dividing the stock's annual dividend by the stock's price, you get a percentage. You can think of that percentage as the interest on your money, with the additional chance at growth through the appreciation of the stock. Although simple on paper, there are some things to watch for with the dividend yield.
Inconsistent dividends or suspended payments in the past mean that the dividend yield can't be counted on. Like water, dividends can ebb and flow, so knowing which way the tide is going —like whether dividend payments have increased year over year—is essential to making the decision to buy. Dividends also vary by industry, with utilities and some banks typically paying a lot whereas tech firms, which often invest almost all their earnings back into the company to fuel growth, paying very little or no dividends.
By combining these methods of valuation, you can get a better view of a stock's worth. Any one of these can be influenced by creative accounting—as can more complex ratios like cash flow. As you add more tools to your valuation methods , discrepancies get easier to spot.
These four main ratios may be overshadowed by thousands of customized metrics, but they will always be useful stepping stones for finding out whether a stock is worth buying.
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