Most people are somewhat familiar with how stock prices work. A share of stock represents fractional ownership in a company. Stocks typically trade on an exchange – such as the New York Stock Exchange or NASDAQ – where market participants buy and sell shares of stocks every day that the market is open and one can easily see how much money it would cost to buy one share of a company’s stock.
Of course, no one knows with certainty whether a stock’s price will go up or down over any period of time but a stock’s price typically depends on factors such as the company’s ability to generate revenues and profits, the outlook for the economy and the company’s industry, and how enthusiastic other investors are about that company or industry, among many other factors. Below we show the price change of one of America’s longest listed companies, General Electric.
One common misconception is that a stock’s price alone shows how valuable a company is relative to another company. For example, if company ABC’s stock trades at $40 per share and company XYZ’s stock trades at $80 per share, surely XYZ is a more valuable company, right? Not necessarily.
The simplest way to understand a company’s value is to calculate its market capitalization, or market cap for short. The formula is simply the price of one share times the number of shares outstanding. If company ABC has 1,000 shares outstanding, the company is worth $40,000 ($40/share X $1,000 shares). If company XYZ has 300 shares outstanding, the company is worth $24,000 ($80/share X 300 shares). Clearly, company ABC is more valuable despite having a lower share price.
So how does someone know if a stock is undervalued and may be poised to increase in price or if a stock is overvalued and should be sold ahead of a decline? Quite simply, no one knows with certainty. However, the commonly referenced Price to Earnings ratio, or P/E multiple, is a way for an investor to compare the relative valuations of two companies. The formula is straightforward: it is the price of the stock (P) divided by the company’s earnings, or net profits, per share (E) and is an easy way to determine how much market participants are willing to pay for each dollar of earnings.
For example, lets say company ABC reported $4 of earnings per share in its latest annual report. It has a price of $40 per share so the P/E ratio of ABC is 10 ($40 / $4 = 10). Company XYZ also reported $4 of earnings per share but its stock trades at $80 per share, so XYZ has a P/E ratio of 20. These metrics are not static; they will change based on the price of the stock and the company’s earnings.
Knowing nothing else about the prospects for either company or what industry they operate in, we can accurately say that market participants are willing to pay more for a dollar of XYZ’s earnings than they are for a dollar of ABC’s earnings today. This may lead to more questions such as “why are people willing to pay more for XYZ’s earnings?” and “will those people be right and earn a profit, or did they foolishly overpay and suffer losses?” Only time will tell.
Instead of looking at past earnings data, an investor can use estimates of future earnings to calculate the forward P/E ratio which is more forward looking than the standard P/E ratio. Of course, an investor cannot rely on the P/E ratio alone but it does give him or her a way to directly compare two stocks when considering a buy or sell decision. There are numerous metrics and calculations people use to compare stocks in an attempt to determine whether a stock is overvalued, undervalued, or fairly valued and many more will emerge from the investment and academic professions.
Disclaimers:
This is for educational purposes only. To learn more about the topics mentioned and if they are suitable for you, consult an appropriate professional. Tax laws can change at any time.
Any information provided in this presentation has been prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for information purposes only and does not constitute a recommendation.
Arthur Stein and Arthur Stein Financial, LLC are not authorized to give legal or tax advice. For information on your specific situation, please consult your tax advisor regarding any tax implications and your attorney for legal implications. As required by the US Treasury Regulations, you should be aware that this presentation is not intended to be used and it cannot be used for the purposes of avoiding penalties under federal tax laws.
Keep in mind that:
Past performance is no guarantee of future performance;
Investments involve the risk of loss of principal and earnings;
ETFs, mutual funds, money market funds, etc. are not guaranteed by the US Government, the FDIC, a bank or anyone else.
“Average annual return” evens out variations in the actual year-to-year returns.
ETFs, mutual funds and individual stocks and bonds fluctuate in value and there will always be times when they lose value.
None of the information provided is necessarily relevant to anyone’s personal situation. Circumstances differ among individuals and you should not assume that these generalizations or information apply to you.
Investments mentioned may not be suitable for all investors.