How Stocks Are Valued
By coming up with their own independent valuations for stocks, investors can potentially identify investment opportunities which arise when a stock is over or undervalued. But how are stocks valued? In this article, we will examine the difference between a stock’s price and its value before highlighting a few methods of how stocks are valued.
Table of Contents
Value vs Price
Before we look at how stocks are valued, it’s important to draw a distinction between a stock’s price and its value. Actually, depending on who you ask, you may receive a difference in opinion as to whether there is a distinction to draw or not.
There are market participants who believe that the markets are perfectly efficient. In other words, they believe that the price of a stock has already taken into account all available news and accurately reflects its value.
However, many investors believe that a stock’s share price does not necessarily always reflect its true value. To quote legendary investor Warren Buffett: ‘"Efficient" markets exist only in textbooks.'
Like any other freely traded asset, a stock’s share price is determined by levels of supply and demand in the market. Consequently, in order for share price to always reflect share value, it would require market participants to act rationally 100% of the time.
To accept that market participants do not always act rationally is to accept that, sometimes, a stock’s share price may not reflect its true value.
How Stocks Are Valued
But how can you determine which stocks are overvalued, which are undervalued and which are fairly valued? How are stocks valued?
There is no one method of valuing a stock. However, there are several well-known ratios which investors may use in order to help ascertain the value of a stock. In the following sections, we will identify and explain three of these ratios, the third of which is typically the most common method of stock valuation.
| Price to Book Ratio |
| Price to Sales Ratio |
| Price to Earnings Ratio |
Price to Book Ratio
A company’s price to book (P/B) ratio demonstrates its current market value in relation to its book value. It is calculated by dividing a company’s share price by its book value per share.
A company’s book value can be calculated by subtracting a business’s total liabilities from its total assets. It can also be found by adding up all the items in the shareholder equity section of a company’s balance sheet. This figure is subsequently divided by the total number of shares outstanding to obtain the book value per share.
A P/B ratio of one would mean that a company’s shares are trading perfectly in line with its book value. A company with a P/B higher than one could be overvalued, whilst a company with a P/B lower than one could be undervalued.
Price to Sales Ratio
The price to sales (P/S) ratio compares a company’s current stock price to its revenue, consequently showing how much the market is willing to pay per share in relation to total revenue.
The P/S ratio is calculated by dividing the current share price by sales per share, which is in turn calculated by dividing total revenue by the number of shares outstanding. Alternatively, the P/S ratio can be calculated by dividing market capitalisation by revenue.
As the P/S ratio focuses on revenue, it is typically used more for valuing the stock of companies which are not yet profit making. It is also used to value companies which have had a loss making year, for example companies which operate in highly cyclical industries.
Price to Earnings Ratio
The most common method of how stocks are valued is by using the price/earnings (P/E) ratio.
The P/E ratio compares a company’s current share price with its earnings per share (EPS), demonstrating how the market values the company in relation to how much money it earns. It is calculated by dividing current share price by EPS.
In theory, if a company has a higher P/E, it indicates that it is expected to increase its earnings at a faster rate than a company with a lower P/E. However, this isn’t necessarily always the case.
It can be the case that a company has a higher P/E ratio than its growth forecast actually warrants. The opposite can also be true.
How to Determine if a Stock Price is Undervalued
Whilst we can say that, generally, it is more desirable for any of these ratios to be lower, what exactly constitutes “lower”?
The problem with these stock valuation methods is that, on their own, they don’t tell us an awful lot. How can you tell if a P/B, P/S or P/E ratio is too high or too low and, consequently, if a company is overvalued or undervalued?
To ascertain whether a company may be over or undervalued, investors can compare one of these metrics to those of companies which operate in the same industry.
For example, if Company A has a P/E ratio of 5, but the average P/E ratio for the industry is 10, we might conclude that Company A is currently undervalued when compared to its peers.
Nevertheless, when valuing stocks, it is important not to take any of these metrics at face value, and to always use them in conjunction with other information.
The example above shows us that Company A is priced lower than its competitors but there may be a perfectly valid reason as to why it has been priced lower. It may face individual headwinds that none of its competitors do. Just because a stock is cheaper it doesn’t necessarily mean it is cheap.
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FAQ
How is a stock valued?
There are a number of methods which investors use to calculate the value of a stock. One of the most common stock valuation methods is using the price to earnings ratio.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
