Copyright 2006 DVK Group, Inc.
Valuation means assigning a “proper” value, or price, to a stock. The quote marks around “proper” remind us that while the word implies that there is a single “correct” price, in fact the concept is theoretical. This is because, in the end, a stock is ''worth'' what particpants in the market for that stock are willing to pay.
Valuation is nevertheless an important guide to what price at which to buy or sell a stock. This is because, over time, what market participants are willing to pay for a stock tends to gravitate to a reasonable perception of what it is ''worth.'' If you pay too much for a stock—more than it is “worth”—your returns will suffer forever after, because the market will bring the price back to its ''fair value.'' On the other hand, because the market price sometimes drifts lower than what the stock is ''worth,'' there are times when the current market price represents a bargain for a particular stock.
Many large-scale institutional investors—mutual funds, brokerages, hedge funds—have developed complex mathematical models for determining a stock’s “proper” price. The individual investor needs to go a different route.
Fortunately, a second method exists which is just as good, easy to understand, and readily available. This second method uses “valuation ratios.”
Valuation ratios divide the stock’s current price (P) by quantifiable aspects of its business: its earnings, its revenue, its book value, and so on. Each ratio is then compared to historical norms to tell whether the stock is fairly priced at its current price P.
Here are some common valuation ratios that the Sensible Stock Investor uses:
• P/E, or price-to-earnings ratio. This compares the stock’s price to the company’s reported earnings. This is the famous “multiple” that one often hears about.
• P/S, or price-to-sales ratio, which compares the stock’s price to the company’s revenue.
• P/B, or price-to-book ratio, which compares the stock’s price to the company’s book value (as computed by accepted accounting principles).
• PEG, which is the P/E ratio divided by the earnings growth rate of the company.
• P/CF, or price-to-cashflow, which compares the stock’s price to its annual flow of cash.
Happily, all of these valuation ratios, plus others, are available for free on virtually all financial Web sites. They are usually current to the very day. If you know the historical benchmarks, it is easy to interpret each ratio as indicating whether, like Goldilocks’ porridge, a stock’s price is too hot, too cold, or just about right.