The price-to-earnings or P/E ratio is a company’s stock price divided by current earnings per share. EPS is a company’s net earnings divided by the number of shares outstanding. When you multiply a stock’s EPS by its current price to earnings, you get the current stock price, or how much investors are currently willing to pay for a dollar of earnings. The lower the P/E, the cheaper the stock. Value investors often use a stock’s P/E to determine if a company is under- or overvalued, or whether the stock is a good buy at the current price.
Figure Out the Current Earnings Per Share
To calculate a company's current stock value, you need to get hold of the earnings per share figure that represents the most recent year of earnings, known as a trailing 12-month earnings per share. You can easily obtain a public company’s long-term EPS growth rate from a financial portal such as Yahoo! Finance or MSN Money, which generally supplies numbers for the past three or five years. Calculate the current EPS growth rate by comparing the EPS for the last two or three quarters to the same quarters last year.
Compare the Figures
The current P/E can be obtained from an extended quote provided by Yahoo! Finance or a similar financial website or portal. Your broker can also supply this number. Now you have the two figures in hand, you can compare the EPS growth with the current P/E. The rule of thumb is that a fully valued stock should have a P/E that equals its earnings growth rate. If the P/E is below the EPS growth rate, the stock is undervalued; if the P/E is above the EPS rate, the stock is overvalued. It's that simple.
Drilling Down into the Numbers
Let's assume that the stock you are researching is fully valued – that is, its EPS growth rate equals its P/E. Substitute the EPS growth rate for the current P/E and multiply it by the current earnings per share (which can also be obtained from a financial portal) to arrive at the stock’s potential value. If the figure is higher than the current stock price, the stock is undervalued; if the figure is lower than the current stock price, the stock is overvalued. You can also use historical P/Es instead of EPS growth rate in your calculations to see if a stock is over- or undervalued by historical standards. You can obtain historical P/Es from a stock data service provider such as Value Line or MarketSmith, a service of Investor’s Business Daily.
Traps for the Unwary
Be careful with these calculations. They are by their very nature theoretical and may or may not lead to profitable results. The market always has a reason for valuing a stock the way it does. On the other hand, extreme market conditions, such as a sharp correction, investor panic or excessive fear, can cause good stocks to be undervalued relative to their underlying businesses or historical averages.