Price-to-earnings (P/E) ratio is a company’s stock price divided by current earnings per share (EPS). EPS is a company’s net earnings divided by the number of shares outstanding. When you multiply a stock’s EPS by its current P/E, 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.
Obtain a company’s long-term EPS growth rate from a financial portal such as Yahoo! Finance or MSN Money 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 EPS growth with the current P/E. The current P/E can be obtained from an extended quote provided by Yahoo! Finance or a similar portal. 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.
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.
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.
Be careful: these calculations are 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.
- “One Up on Wall Street”; Peter Lynch; 2000