How to Value Common Stock

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A company’s common stock is only worth what investors are willing to pay, so the market price on any given day is its value. Valuing a stock really means assessing the company’s financial condition, profitability and growth potential. Financial analysts have developed a range of measures to evaluate stocks to help investors make wise decisions.

Price-to-Earnings Ratio

The price-to-earnings ratio measures the market price of the stock to the company’s profitability. The formula is market price divided by earnings per share. Traditionally, investors use the average market price for the four previous quarters to compute P/E. Suppose a company earns $2.50 for every outstanding share of common stock, and the stock price is $40. The P/E ratio is 16:1, or simply 16. P/E ratios are usually somewhere in the middle to upper teens. The higher the P/E ratio, the more expensive the stock is relative to the company’s profitability. Don’t assume a high P/E means a stock is overpriced. It may indicate investors think earnings are going to improve in the future. Conversely, a low P/E may signal problems with the company, rather than a bargain price.

Price-to-Book Value Ratio

The book value of a company’s common stock is the shareholders’ equity stated on its balance sheet minus the book value of preferred stock. Divide this figure by the number of outstanding common shares to find book value per share. Divide the market price by the result to compute P/B ratio. Suppose a firm’s book value per share is $25 and the market price is $40. The P/B ratio works out to 1.6. P/B ratio tells you how much a share of common stock is worth on paper, but it may not accurately assess the stock’s real value. Book value includes “intangibles,” which are estimates of the worth of things like goodwill and brand names. Companies that rely heavily on intangibles, like those in the consumer products or pharmaceutical industries, tend to have relatively high P/B ratios.

Dividend Yield

Deriving income from investments is important to some investors, so they are likely to seek out common stocks that pay good dividends. Dividend yield is calculated by dividing the yearly dividend by the stock price. A stock selling at $40 with an annual dividend of $1.60 has a dividend yield ratio of 4 percent. Not all common stocks pay dividends. Growth-oriented firms may choose to plow profits back into the company to fuel expansion instead of paying dividends. Income-seeking investors are likely to prefer common stocks with a history of consistent dividend payments. Typically, these are well established firms and are usually viewed as safer investments than growth-oriented companies.

EPS and EPS Growth Rate

Another useful measure is earnings per share, which tells you how much profit a company makes for each share of common stock. To calculate EPS, subtract preferred stock dividends from a firm’s net income and divide the result by the number of common shares outstanding. If a company earned $15 million and has 7.5 million shares outstanding, EPS equals $2.00. It’s also helpful to know if the company’s EPS is growing. EPS growth rate is figured by subtracting the previous year’s EPS from the current year’s EPS and dividing the difference by the previous year’s EPS. If the previous year’s EPS was $1.60 and the current year’s EPS is $2.00, you have a 25 percent annual growth rate.