When you're buying stocks, the first thing you might look at is the price. But a stock's price and its value aren't the same things. Looking at a stock's value helps you decide if its current price is cheap or expensive. This can help you decide if it is worthwhile to invest in or not.
Knowing a stock's price is simple. Knowing its value, though, is a bit more complex. But It's not impossible, even for the average investor.
Three of the most important data points for finding a stock's value are its EPS, as well as its P/E and PEG ratios. Learn more about what these are and how they can help you decide where to invest your money.
- A stock's price and value aren't the same things, and value is more complex to find than price.
- Earnings per share (EPS), the price-to-earnings (P/E) ratio, and the price/earnings-to-growth (PEG) ratio can help you find a stock's value.
- Separating a stock's price from its value is an essential part of knowing what a share is worth.
Why Doesn't Price Always Tell You a Stock's Value?
It's tempting to buy as many stocks with low prices as you can and hope they will go up in value one day. But the cheapest stock may not provide the best real value.
A $5 stock may seem like a bargain at first glance. If you're dealing with an unstable startup, though, you may not see the best return on the money you invest. On the other hand, a more costly stock that trades at $150 can be harder to decide to invest in. But if it comes with dividends and a stable history of growth, it may be a safer place to put your money.
A stock's value is tied to more than just how old the company is. There are three data points that can reliably show you a stock's value beyond share price. These are the earnings per share (EPS), the price-to-earnings (P/E) ratio, and the price/earnings-to-growth (PEG) ratio.
How Can You Use EPS to Find a Stock's Value?
Many amateur investors think the price of a stock, whether it is "cheap" or "expensive," is the same as its value. But treating these as the same thing can lead to unwise investment choices.
For example, let's look at two imaginary company's stocks.
Smith Organic's shares sell for $10, and Jones Organic's sell for $2,000. Which is cheaper? At first glance, it may seem like Smith's stocks are much cheaper and thus the better value. But that might not be true. That's because of something called "earnings per share" (EPS). Earnings per share, or "EPS," measures a stock's value based on the company's net profit and the shares outstanding.
Say Smith's Organic has a million shares outstanding, but Jones Organic has only 1,000 shares outstanding. If both companies make a million dollars in profit every year, Jones Organic gives you more bang for your buck. That's because it has a much higher profit per share.
- Smith Organic: $1,000,000 profit / 1,000,000 shares = $1 profit per share
- Jones Organic: $1,000,000 profit / 1,000 shares = $1,000 profit per share
Each of Smith Organic's 1 million shares is worth $1 of its profit. But Jones' 1,000 shares are worth $1,000 each, which is a much higher value. Even though one Jones Organic share costs more than one Smith share, it's 100 times more valuable.
But EPS should not be the only data point you use to select a stock.
Using P/E to Understand a Stock's Value
Another popular option for evaluating stock prices is the price-to-earnings (P/E) ratio. The P/E ratio provides an indicator of how much investors will pay for each unit of earnings. Companies use this metric to gauge if their stock price is lower or higher than it's been in the past. It can also be used to compare the value of stocks between companies.
To find the P/E ratio, divide the current stock price by the current earnings per share. If a stock has a P/E ratio of 50, then, investors are willing to pay $50 for each dollar of profitability.
Typically, companies want to have lower P/E ratios. The lower it is, the better it makes the stock look.
A good rule of thumb for many investors is to look for a P/E ratio of 20 or less. But beware of a value trap. This is when a stock seems cheap due to low P/E, but that low P/E implies dim future earnings prospects. Stocks like this may not be a sound investment.
Stocks with a low P/E ratio are less expensive to purchase than those with a high P/E ratio. By buying these stocks at a lower price, some investors hope that stocks with a low P/E ratio will rebound. If this happens, the investors will make a profit.
Here is an example of what it looks like to find P/E:
- Smith Organic: $10 price per share / $1 profit per share = P/E of 10
- Jones Organic: $2,000 price per share / $1,000 profit per share = P/E of 2
Smith Organic's $10 stock is still much cheaper than Company Jones Organic's $2,000 stock. But the Jones stock has a better value because it has a lower P/E ratio.
Using PEG to Understand a Stock's Value
The price/earnings-to-growth ratio, or PEG, sounds similar to a P/E ratio. It has a different way of looking at value, though. This can help you decide if a stock is undervalued or overvalued.
To find a stock's PEG, take the P/E ratio and divide it by the growth rate. In some cases, PEG ratios can provide a clearer picture of a stock's value than the P/E ratio. If the value is more than 1, the stock is overvalued compared to its growth rate. If the value is 1 or less, then it is at par or undervalued in comparison to the stock's growth rate.
At the end of the day, the lower the PEG ratio is, the better the value generally is. The lower ratio means you will pay less for every unit of earnings growth you obtain if you invest in that stock.
Let's look at Smith Organic and Jones Organic again. You can calculate their PEG ratio, assuming a 5% EPS growth rate for both.
- Smith Organic: P/E of 10 / 5% annual profit = PEG ratio of 2
- Jones Organic: P/E of 2 / 5% annual profit = PEG ratio of 0.4
Jones Organic turns out to be a more valuable buy, even using this metric.
PEG also delves deeper into a company's earnings prospects beyond the EPS. It can be used to compare stocks of companies across different sectors and industries.
Suppose a tech stock is trading at a P/E of 20, while a manufacturing stock P/E is 15. It would seem that with the lower P/E, the latter would be a good buy.
Given the growth of the tech industry, though, that tech stock might have a growth rate of 30%. The manufacturing company might only have a growth rate of 10%. A PEG analysis, then, would show a very different picture.
- Tech stock PEG: 20 / 30% = 0.67
- Manufacturing stock PEG: 15 / 10% = 1.5
In this case, the tech stock has a high P/E. But it also has a lot of potential for earnings growth. This could mean that it's still a solid choice for where to invest.
The Bottom Line
Knowing the difference between a stock's price and its value is essential to understanding what a share is worth. EPS, P/E ratios, and PEG ratios can help show the value of a stock in more useful ways than just the sticker price. The PEG ratio provides extra perspective, as it uses the P/E ratio to provide further insight on growth rate. Which method you use to decide if a stock is too costly or a good buy is up to you.