Ratios to Assess Stock Value for Beginners
For a lot of us playing the stock market seems like risky business, which needs an extremely high level of expertise. The stock market seems full of complexities. How to pick a stock, which sector, how to assess their performance are all questions that most beginners ask.
There are some basic ratios that are used to value stocks. They are:
- Price to Earning ratio(P/E ratio)
- Price to Book ratio (P/B ratio)
- Price to Earning Growth ratio (PEG ratio)
- Dividend Yield
The Price to Earning ratio refers to the price of the stock to profit (or net income). It is also known as multiple. Typically a stocks market capitalization to its total annual earnings will give its PE ratio.
PE ratio = Price per share/ Earning per share
Say the price of the share is $32 and its earning per share is $8, then its PE ratio would be 4. That is assuming inflation stays constant as does the time value of money it would take 4 years for the share to pay back its purchase price. The PE ratio is used to value stocks in the same sector. Companies with stronger earnings generally attract better valuation as compared to riskier lower expected earning stocks.
Price to Book ratio measures the price of the share to the book value of the share.
PB ratio= Stock Price/(Total Assets - Intangible Assets and Liabilities)
This ratio helps assess if investors are paying too much for the stock, should the company go bankrupt tomorrow. This ratio does not value brand value or other intellectual property, on which companies are valued. In that sense this ratio has limited scope.
Price to Earning Growth ratio is arrived at by dividing the PE ratio by the growth on earnings per share. This ratio is preferred by investors as it factors in growth in earnings. This ratio can be used in say comparing stocks of supposedly high expected growth companies (e.g. technology) with perhaps a more traditional company (e.g. Book publishing). This will help us understand if a particular stock is overvalued.
Assume that the technology company has a high PE ratio of 50 and an annual expected growth of 25%. The book publishing company has a PE ratio of 20, and expected growth of 5%.
The PEG ratio for the technology company is 2, while that of the book publishing company stands at 4. Despite better expected rate of growth, the book publishing company seems a better bet and the technology firm overvalued.
Dividend Yield is the inverse of the PE ratio. This ratio helps understand how much cash you will get for the money you have invested in the stock. A company that has a steady and high dividend is preferred by investors. A high dividend yield could mean the company has reached its peak as far as payouts are considered or that it is undervalued. Low dividend yields mean one can expect better payouts in the future or that the stock is overvalued.
These ratios used together can help a beginner seek his way better through all the stocks in the market that vie for their attention.