Valuation methods are the methods used by investors and stock analysts when they want to know whether the market price of a company’s share is a good deal relative to the underlying value of the piece of the company the share represents. They also want to know how the company compares financially to its peers.
Different methods of valuation help investors to assess a company’s financial performance in relation to its stock price:
- Earnings per share (EPS). EPS equals net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company’s financial performance. If it falls, it will likely take the stock’s price down with it.
In other words, EPS is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.
EPS is calculated as:
EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares
- Price-to-earnings ratio (P/E). The P/E ratio is the current price of a share of stock divided by the previous 12 months’ earnings per share. It’s a common measure of how cheap or expensive a stock is relative to earnings.
In order words, the price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
The P/E ratio can be calculated as:
Market Value per Share / Earnings per Share
- Price-to-book ratio. This is the current market price of a share of stock divided by a stock’s book value per share. (To calculate the book value, subtract the preferred stock total from total equities, and then divide the result by the number of shares outstanding)
The Price to Book Ratio – P/B Ratio is used to compare a firm’s market to book value and is calculated by dividing price per share by book value per share.
Also known as the “price-equity ratio”.
P/B Ratio = Market Price per Share / Book Value per Share
where Book Value per Share
= (Total Assets – Total Liabilities) / Number of shares outstanding
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.
This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.
- Growth indicators. When a company grows (in sales, profitability, or earnings per share), it can provide increasing returns to its shareholders and opportunities for employees. In industries with long business cycles (like oil and gas), analysts measure a company’s growth over numerous years. In industries with short cycles (like the internet), analyses measure growth over fewer years maybe even just one.
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