How much is too much to pay for a stock? There’s a lot of science involved in answering that question — and a whole lot of art.
On Wall Street, deciding whether a stock is expensive, cheap, or something in between starts with its “valuation.” To gauge a stock’s valuation, investors look at ratios. The most common is the ratio of a company’s stock price to its earnings per share, known as a P/E ratio.
But ratios don’t stop there. Far from it. Sometimes they even include ratios calculated with another ratio. One example is the PEG ratio, which is the ratio of the P/E ratio to the company’s rate of earnings growth.
There are many other ratios and more math. This is the science of valuation.
Interpreting those ratios is an art. Usually, cheaper is better if only because if you pay a high price for a stock, you will earn a lower return, all else being equal.
Of course, all else is never equal. Things change, sometimes rapidly. That’s why any valuation ratio needs to be seasoned with skepticism and experience. There is no perfect number that screams “Buy me now!”
It’s all relative. The S&P 500 trades, today, for about 22 times estimated 2021 earnings. That’s up from a historical average of about 19 times over the past five years. Any company’s P/E ratio should be compared to that. Companies that are stable and growing will earn a higher valuation than companies with growth problems or other issues.
Finally, it’s important to remember that it doesn’t really matter what happened in the past — the market is always looking ahead. Investors should always be thinking about what valuation looks like based on future earnings.
There are, of course, other things to know, such as how to value companies that have earnings that rise and fall with the economic cycle, or small-cap companies that could be acquired.
Learning all the quirks of valuation simply comes with experience — but it provides a lifetime of rewards. We’ll explain all that and more in the video. But first, a test of your valuation knowledge:
What’s the difference between a trailing P/E ratio and a forward P/E ratio?
For the answer and more, watch this video.