How to Value a Stock - Cheap or Expensive?

If youre new to investing, learning how to choose stocks and investing in the stock market can be overwhelming. Probably the largest mistake that
young investors make is to look at the price of a stock as a measure of its worth. In fact, the price of a stock is virtually worthless when trying to value a
company.

So what metrics should investors use when evaluating a potential stock investment opportunity? While there are numerous factors to take into
consideration, the most popular and well-known metric is known as the price to earnings ratio, or the P/E ratio. But before we get into explaining this
ratio, lets look at why the price of the stock doesnt tell the whole story.

Stock Prices Cheap Vs. Expensive

Think about something in your life that you know very well. Maybe youre obsessed with computer upgrades and performance. You know everything there
is to know about computers and when you go to a computer store; when you look at the prices and the specs, you truly know what represents a bargain.

If you were helping a friend pick out a computer, you might tell them that a computer on sale for Rs 20,000 may be a better bargain than a computer on
sale for Rs. 18,000. Maybe the Rs. 20,000 computer has a bigger screen, more storage space, and Rs. 5000 of preloaded software on it. With the Rs.
18,000 computer, not only is the hardware pretty shoddy, but there is also no preloaded software, meaning youll have to shell out extra money once you
buy the computer. You might say you get more bang for your buck with the Rs. 20,000 computer. It is this same line of thinking that should be applied
to stocks.

Unfortunately, many young investors do not apply the same logic to stock picking. Instead, they look at a Rs. 2500 stock like TCS and call it expensive.
So they head to a little known penny stock that is selling for Rs. 0.50 and buy it up like its pure gold. The fact of the matter is that if you only have Rs.
2500, theres a good chance that youll make more money purchasing 1 share of TCS rather than 5,000 shares of that cheap company. Why?
Because TCS is a much more stable company with not only a proven track record of making investors money, but also strong growth potential.

The P/E Ratio Defined

Now that weve fixed the flaw in the young investors logic, lets look at how to measure value. Its a little more complicated to evaluate stocks than it is
to evaluate computers since there are so many different factors involved.

However, there is one metric which, while it doesnt make up the entire story, offers an important piece of the puzzle when valuing a company: the
price/earnings ratio, often referred to as the P/E ratio or P/E multiple. This ratio, while only one of many that sophisticated investors use, is the most
popular and discussed ratio in many investment books.

So how does the P/E ratio work? Think of it this way: lets say you are considering investing in two public companies, both of which are selling for Rs. 200
per share today. One way of deciding which company to invest your money in is examining how much you will need to pay for Rs. 10 of earnings from
each company. If last year, Company A earned Rs. 50 per share and Company B earned only Rs. 40 for share, it would intuitively make sense to choose
Company A over Company B since it represents a cheaper trading opportunity. Without even realizing it, youve made this decision by calculating each
companys P/E ratios.

The P/E ratio is calculated by taking the current price and dividing it by the earnings per share. In the example above, you would take the price of Rs.
200 and divide by Rs. 50 for Company A and Rs. 40 for Company B, yielding ratios of 4x and 5x, respectively. If youre not good with math, you can also
easily find the P/E ratio in the fundamental analysis section of your brokers research screens for the stock youre reviewing or on various stock market
investment news and research sites.

Disadvantages of the P/E Ratio

While the P/E ratio is a valuable metric for investors, you dont want to make the mistake of thinking that a P/E ratio alone tells the whole story. Here are
the main limitations of the P/E ratio:

1. Healthy P/E ratios may differ between industries: The concept of using a set P/E ratio to determine if a stock is overpriced fails to take into
account the individual nature of the underlying company. Stocks in high-growth industries like the technology industry tend to have higher P/E ratios. On
the other hand, some industries such as utility companies tend to trade at much lower multiples. Before you can decide if a stock is under or overpriced,
you need to take into consideration the industry in which it operates. Continuing with the example above, lets say Company B was a high-growth tech
company forecasted to earn Rs. 100 per share next year and Rs. 150 per share the following year, while Company A was a low-growth oil company that
was forecasted to earn Rs. 60 per share next year and Rs. 70 per share the following year. Now that you have a fuller picture of the two companies, it
becomes clear that Company B would in fact be the better company to invest in due to its massive growth potential. Company Bs stock price will likely
skyrocket if the forecasts are correct, while Company As stock price may not budge by much over the next couple of years. Thus, by ignoring other
aspects of the company, an investor might have falsely assumed that Company A represented the more valuable stock opportunity.

2. Fails to consider the debt of a company: The price of a stock reflects the equity value of a company. However, it is also important to consider how
much debt the company holds. An investor should never ignore a companys debt position when buying a stock since debt is a strong indicator of a
companys financial health and future.
3. Earnings can be manipulated easily: Clever accountants have a million and one ways to make companies look more attractive. This can involve
changing depreciation schedules, using different inventory management strategies, and including non-recurring gains. These strategies are not limited to
corrupt organizations, as firms are given some legal flexibility in how they choose to report their earnings. As a result, because companies have an
incentive to make earnings look as attractive as possible, P/E ratios can be presented as being artificially low.

4. Growth companies trade at higher P/E ratios: Since P/E ratios represent not only a companys current financial situation but also its future
growth potential, growth stocks trade at significantly higher P/E multiples than value companies. Thus, without understanding what type of company you
are considering as an investment, you might carelessly overlook some valuable growth companies simply because of their P/E ratios. In fact, some of the
biggest winners of all time have been companies with high P/E ratios. Yet according to the models of most investors who rely solely on P/E ratios, all of
these companies would have been ruled out as being overpriced.

5. False assumption that low P/E ratios represent cheap trading opportunities: Many investors assume that a company trading at a P/E ratio
must represent great value. As we know, because of many of the factors stated above, low P/E ratios do not necessarily make the best investments. For
example, Suzlon was a company that was trading at single digit P/E ratios before it crashed.

P/E ratios are a valuable tool for investors, but they are not sufficient to identify the feasibility of an investment unless used in combination with other
metrics and company characteristics.

Regardless of your opinion on the P/E ratio, you should always examine other ratios as well before buying a stock. These metrics, which help investors
evaluate other aspects of a company, include Enterprise Value/EBITDA, Enterprise Value/EBIT, Enterprise Value/Revenue, Price/Cash Flow and Price/Book
Ratio.

Final Word

The P/E ratio is a great start to understanding a companys value proposition as a potential investment. With that said, dont forget that there are many
other ratios and factors to consider other than the P/E ratio. The P/E ratio is just one piece of the puzzle. And if you only take one lesson from this post,
remember this nugget of information: the price of a stock is not an indicator to identify value of it!