Do you have questions about how to properly value a stock? If so, then you are not alone.. So, many investors struggle with knowing where to start when doing a stock analysis. Below is a guest post by Barb Friedberg that will help to shed some light on this situation.
Barbara Friedberg, MBA, MS, is editor-in-chief of Barbara Friedberg Personal Finance.com where she writes to educate, inspire, and motivate for wealth in money and life. Learn about personal finance from a real life Portfolio Manager!
One Step Stock Analysis
Use the Price Earnings Ratio!
Over the past 15 years I’ve worked as a Portfolio Manager, and for an additional five as an individual stock investor. Analyzing stocks is a time intensive activity requiring financial statement study, company, and industry research. So where do I get off with the suggestion that you can analyze a stock with one step?
Okay, the title isn’t exactly accurate, but I got your attention didn’t I? A better title would be “Rule out Suitable Stocks for Investment Fast with P/E Analysis.” But that title is a bit cumbersome, don’t you think?
What is a P/E Ratio?
A P/E ratio is one way to measure how expensive or cheap a stock is. Simply put, take the current price of a stock and divide it by the earnings per share. You can use the past years earnings or next year’s estimated earnings (forward), or a combination of the two. Generally, I prefer using next year’s earnings, even though it is usually a bit more aggressive.
Try it Out
Follow along using Walmart as an example.
Walmart (WMT) price = $54.21
Earnings per share (forecast for next 2012) = $4.45
FORWARD P/E RATIO=$54.21/$4.45 = 12.18
Where to Get the Numbers?
- Go to Yahoo Finance.
- Type in the ticker symbol, WMT in the quote box and up comes the quote, along with some additional fundamental information including the trailing (based on last 12 months earnings) P/E.
- Click on the left side of the page under Analyst Coverage, the heading called Analyst Estimates. Choose Average Estimate for Next Year.
- Walmart’s average analyst estimate for 2012 = $4.45
If you’re super lazy you can just take the P/E ratio from the Yahoo Finance quote!
What Does the P/E Ratio Mean?
The 12.18 P/E from Walmart is the estimated amount of earnings that one dollar will buy. P/E ratio analysis is a method for determining the value of the stock. If you go into the supermarket, you know that $3.00 per pound is an expensive (or overvalued) price to pay for apples! But how do you know if a stock is fairly priced or not?
The higher the P/E, the more expensive the stock is and the more the market is willing to pay for that stock. Generally, stocks with higher P/E ratios (growth stocks) are expected to grow more quickly and produce higher profits than those with lower P/E ratios (value stocks).
The number in and of itself is less meaningful than it’s comparison with other P/E ratios in the industry or those previous P/E ratios of the same company.
How to use a PE Ratio?
Now that you know Walmart’s expected or forward Price Earnings ratio, you need to know how to use it. You want to know whether Walmart is fairly priced, underpriced, or overpriced according to its P/E ratio.
To continue you need two additional P/E ratios; the Historical average P/E ratio for Walmart and the Industry average P/E ratio for Walmart’s competitors. Follow along, they’re easy to obtain!
Find industry P/E ratio:
- Look up the industry data back at Yahoo Finance.
- Beneath Company, click on Industry .
- In the middle of the page click on More; Discount Variety (Walmart’s industry). Next go to Industry Summary.
Discount Variety Industry P/E = 14.2
Find Walmart’s historical average P/E ratio:
Head over to Morningstar.com to find Walmart’s historical P/E ratio. Although they have a membership option, there’s also lots of free information.
- You know the drill; input WMT into the quotes box.
- Along the top menu follow the links: Key ratios >Valuation
- Take the average of the past 5-10 years of P/E ratios.
5 Year historical Walmart P/E average = 15.34
Buy, Sell, or Hold?
To say that a P/E analysis is all you need to determine whether to buy a company’s stock would be irresponsible. But, it is a starting point to determine whether to continue with your analysis.
- WMT forward P/E = 12.18
- WMT historical P/E = 15.34
- Discount Variety Industry P/E = 14.2
Analysis: Walmart’s forward P/E at 12.18 is lower than both the company and industry P/E ratios. In fact, WMT’s P/E of 12.18 is 21% below its own historical P/E ratio of 15.34. This suggests that according to future expectations about the growth of Walmart, the price is UNDERVALUED.
According to this simple P/E ratio analysis, Walmart merits FURTHER STUDY.
Thinking about investing in a particular stock? Do a quick Price Earnings Ratio study and decide whether the company is worth a second look or not.
Caveat: This article is for informational purposes only and not a recommendation to buy or sell. Before investing, consider your own personal situation.
What do you think is the most important measurement to consider when stock investing?