How To Tell If A Stock Is Cheap: Learn How To Calculate A P/E Ratio and P/E To Growth Ratio

For those new to investing, or managing their own money, there are plenty of confusing things about the business and therefore plenty of opportunities for mistakes. Whether you are trading actively or investing in individual stocks for long-term holding, there are some mistakes that are common and repeated all-too-frequently by those new to the game.

The most common of these is a misunderstanding of what represents value in a stock, and what constitutes “cheap” and “expensive.”

Oscar Wilde once said that the problem with young people was that they knew the price of everything, but the value of nothing and it has been said in one way or another of every generation since. Unfortunately, it is also true of a lot of investors early in their involvement in the market.

Price and value are different things, and price is only important in the context of value. Let's pretend there are two stocks, ABC and XYZ. ABC is a stock that sells for $5, but it might not be cheap; XYZ, which sells for $1,000, may not be expensive. Why is that?

It's because shares represent fractional ownership of a corporation, but there is no rule as to what fraction each represents nor how many shares are issued. What matters is the total price that the market puts on the company, what is known as “market capitalization.”

If, for example, there are a million shares of ABC in circulation and only a thousand of XYZ, then ABC as a company is priced at $5 million, five times higher than XYZ:

  • ABC: $5 per share X 1,000,000 shares = $5,000,000
  • XYZ: $1,000 per share X 1,000 shares = $1,000,000

If we further assume that both companies make a million dollars each year in profit, then each of the 1 million shares of ABC represents $1 of that profit, while each of the 1,000 shares in XYZ represents $1,000.

  • ABC: $1,000,000 profit / 1,000,000 shares = $1 profit per share
  • XYZ: $1,000,000 profit / 1,000 shares = $1,000 profit per share

On that basis, a share of XYZ stock should be valued at 1,000 times the price of ABC, not 200 times. XYZ may be higher in price, but in terms of how much profit it represents, it is actually “cheaper” than ABC.

The market shorthand for that relative value is what's known as the Price to Earnings Ratio, often shortened to the P/E and sometimes referred to as the stock’s “multiple.” It is calculated by dividing the price of each share by the profit it represents.

In the example above, the P/E of ABC would be the price of each share, divided by the earnings it represents, giving a P/E of 5. XYZ’s P/E would be 1 (see math below). The lower the P/E ratio, the better the value a stock represents, so once again, the $1,000 stock here is much better value than the $5 example:

  • ABC: $5 price per share / $1 profit per share = P/E of 5
  • XYZ: $1,000 price per share / $1,000 profit per share = P/E of 1

The other factor to consider when evaluating a stock is earnings growth. To some extent, investing is always about predicting, or at least making assumptions about the future and this is an example of that. If a company is growing rapidly, then its stock may be worth more than its P/E suggests and worth more on a relative basis than stock in a company whose sales are no longer growing.

When you factor in that consideration, you get another ratio, this time P/E to Growth, known as PEG.

The PEG ratio is calculated by dividing a stock’s P/E by the rate at which the company is growing. That is what Wall Street analysts predict will be the growth rate over the next year. If two companies’ stocks each have a P/E of 10 but company A grows profits by 10% a year while company B achieves only 5% growth, their PEG ratios would be 10/10 = 1 for A, and 10/5 = 2 for B

  • Company A: P/E of 10 / 10% annual profit = PEG ratio of 1
  • Company B: P/E of 10 / 5% annual profit = PEG ratio of 2

With the same current profit, but better growth, A is the better value so as you can see, a lower PEG, just like a lower P/E is considered better than high in value terms.

When evaluating a stock, value, however it is calculated, is not the only concern. Some companies have value based on their potential even if they don’t make money.

A good example from the recent past would be Amazon (AMZN), which ran at a loss for a long time. If you bought the stock during that time, though, you would have done well.

One should also consider the broader economic outlook, market trends, management effectiveness and plans, and a whole host of other things if you are fully analyzing a potential investment. None of that, however, can be assessed accurately unless you understand the difference between price and value, and hopefully, if you have read this far, you now do.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks , Investing Ideas , US Markets

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