As stocks continue hitting record highs in 2021, valuation is starting to look like a lost art.
But make no mistake… adding valuation skills to your toolkit is an important step in becoming a successful long-term investor.
This is true whether you’re a value investor or a growth investor.
That’s because valuing stocks can help you find attractive opportunities while avoiding riskier, overhyped stocks.
In this two-part lesson, I’ll explain how to use five different ratios to help you value a stock. Today, we’ll start with two favorites: The P/E and PEG ratios.
Why valuation is important
One of the greatest skills an investor can learn is how to value a company. That’s because a stock’s value is typically separate from its market price.
This is a critical idea for investors to understand.
The “father of value investing,” Benjamin Graham, is credited with saying, “In the short-term, the stock market is a voting machine.” Graham literally wrote the book on valuing stocks back in 1934. His ideas fueled an entire generation of great investors, including Warren Buffett.
His quote captures the idea that emotions drive the daily moves in the stock market. We can see it as stocks surge or decline each trading day.
These price swings can lead to stocks becoming overvalued or undervalued. Valuation metrics help investors determine whether a stock is worth buying. These ratios measure the relationship between the price of a stock and fundamentals like sales or earnings.
Let’s start by looking at two of my favorite valuation ratios…
Price-to-Earnings
The price-to-earnings ratio, or P/E, is one of the most common valuation metrics for analyzing stocks. This ratio measures the current market value of a stock compared to its earnings. It shows how much the market is willing to pay for a company’s earnings—either in the past or in the future.
A trailing P/E compares a stock’s price to the company’s earnings over the past 12 months. A forward P/E works the same way, but uses expectations for future earnings over the next 12 months. The easiest way to get this number is to use consensus earnings estimates—the average forecast from all the analysts that cover a company.
A high P/E could mean that a stock’s price is too high relative to its earnings and therefore overvalued. On the other hand, a low ratio could indicate the stock is cheap compared to its earnings.
Let’s use Tesla (TSLA) as an example…
Tesla has a trailing P/E ratio of 954.7. We get this number by taking Tesla’s recent price of $611 and dividing by its trailing twelve-month earnings per share (EPS) of $0.64. With a P/E over 900, Tesla is widely considered overvalued.
Tesla P/E = 611/0.64 = 954.7
Another example is eBay (EBAY), which has a trailing P/E ratio of just 6.7. Again, we calculate this by dividing its recent share price of $53 by its trailing twelve-month EPS of $7.89.
eBay P/E = 53/7.89 = 6.7
There’s no definitive line for deciding whether a stock’s P/E ratio makes it cheap or expensive. Typically, value investors look for a ratio under 20. But it’s helpful to compare the P/E of a stock to its industry average.
For instance, Tesla is in the automotive industry. Another prominent stock in this sector is General Motors (GM). GM’s trailing P/E is 11.8, much lower than Tesla’s. So, in this instance, Tesla is extremely overvalued when compared with GM.
High P/E’s aren’t always a bad sign, especially if you’re looking at growth stocks. A high P/E suggests investors believe the company’s future earnings will grow… sometimes by a lot. That’s why Tesla’s stock has outperformed GM in recent years—the market has been willing to pay a premium for Tesla’s growth. If the company doesn’t meet investors’ rising expectations, the stock could fall sharply.
In short, the P/E ratio is a great starting point for valuing companies. But we need to dig deeper to find out if a stock is a good buy.
Let’s look at another valuation metric that includes a company’s growth…
PEG Ratio
As I mentioned above, the P/E ratio doesn’t take earnings growth into account. The PEG ratio helps fix this limitation.
To find the PEG ratio, you first need to calculate the P/E ratio for a stock. Next, simply divide the P/E by the company’s expected earnings growth. I prefer to use a company’s projected five-year growth rate for earnings per share (EPS). I use the consensus growth rate of Wall Street analysts.
Let’s continue with our Tesla example…
To calculate Tesla’s PEG ratio, we take its P/E of 954.7 and divide it by its projected five-year growth rate. You can find growth estimates for stocks at Yahoo Finance by punching in the ticker and clicking on the “analysis” tab. For Tesla, it shows a five-year growth rate (in percent) of 32.1. This gives us a PEG ratio of 29.7 for the stock.
Tesla PEG = 954.7/32.1 = 29.7
Let’s also check the PEG for eBay. As we calculated above, eBay has a trailing P/E of 6.7. If we divide this number by its five-year growth rate of 18.8 (again, scroll down on the “analysis” tab in Yahoo Finance), we get a PEG Ratio of 0.36.
eBay PEG = 6.7/18.8 = 0.36
A stock with a PEG ratio under 1.0 is generally considered cheap. This is because its price is low compared to its expected earnings growth. Similarly, a stock with a PEG ratio over one is generally considered overvalued. This indicates a stock’s price is too high compared to its expected earnings growth.
Tesla’s PEG ratio is 29.7, well above 1.0. Meanwhile, eBay’s PEG ratio was 0.35, well below 1. Similar to our P/E calculations, the PEG ratios tell us that Tesla appears overvalued, while eBay looks attractive.
The PEG ratio gives us a better picture of a stock’s value relative to its growth outlook. While the P/E ratio only looks at current earnings, the PEG ratio adds a growth factor, which is critical when you’re deciding whether to invest in a company.
Taking Action
I’ve covered two different valuation ratios you can use to evaluate stocks. The P/E and PEG ratios are a great starting point—they aren’t enough to decide whether you should buy eBay or Tesla. Make sure to compare stocks within the same industry. Also, it’s best to look at multiple ratios… you should never rely on a single ratio for your research.
Next week, I’ll cover three more valuation metrics. I’ll also explain the other important factors investors need to consider, including a company’s balance sheet health and its historical results.
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