Stock valuation is comparing one stock to another, or a group of stocks, to evaluate the merits of an investment. This form of fundamental analysis is beneficial because it assesses the stock's value over the long term. Valuation analysis uses metrics and ratios in order to grasp the value of the stock and whether it is a buy, sell or hold.
Investors who use valuation look at key aspects of a company in deciding if the stock is undervalued or overvalued. If the stock is undervalued, then it may be worth purchasing. However, if it is overvalued, then it may not be worth buying. A valuation investor may look at a company's financial stability, earnings growth, or the effectiveness of the management. Looking at a company's projected earnings would be an objective valuation, while valuing a company's management would be subjective.
Price-to-Earnings Ratio (P/E)
The price-to-earnings ratio is a key factor in stock valuation. The P/E ratio compares the company's current share price and per share earnings. For instance, if the share price is $25 per share and the earnings per share (EPS) is 1.23 then the P/E ratio is 20.3. This is important. Investors believe that a higher P/E indicates fast growth and thus are willing to pay more for stocks with a high P/E. In theory, for a P/E of 20.3, investors are willing to pay $20.3 per $1 of current earnings. The price-to-earnings ratio is also called the "multiple."
In a Nutshell
Ben McClure, McClure& Co., explains that valuation allows the investor to simplify information into corresponding ratios and metrics. This allows the investor to compare multiple companies at once. However, he explains that valuation can be flawed because it can be based on observations. McClure gives the example of how Kmart became a favorite among investors in 1999 because it appeared cheap compared to supposedly overvalued Walmart and Target. Investors failed to note Kmart's flawed business models, and the company filed for bankruptcy in 2002. "Do your homework," says McClure. It is better to used various methods and tools in deciding the value of a company.