How Stocks Are Valued
Stock valuation is a crucial step when making investments.
It is the means by which an investor determines the real worth of shares with a basis of certain fundamentals in a bid to inform decisions of buying or selling.
The representation of a company’s cumulative value or its market capitalization is usually through the price of its stocks. The stock, though, is a relative representation as it only represents a percentage change at any point in time.
Hence, to get the actual market capitalization, the stock price is multiplied by the total number of shares outstanding.
To illustrate: Let’s say company ABC is trading at $10.50 as at July 13, 2017. It also has 70 million shares outstanding. The correct valuation of company ABC will be $10.50 x $70 million=$735 million
The stock price is the main variable here as any change in it will result in a corresponding change in the value of the company. Investors should place more focus on it when valuing a company as it could lead to massive loss of investment capital.
How Stock Prices Are Calculated and Who Sets Them
The stock prices of most companies are determined during the Initial Public Offering. Investment banks apply various formulas and techniques in this regard.
Typically, a company that’s valued at say, $200 million may want to issue 20 million shares at $20 per share or probably 40 million shares at $10 per share. Of course, the forces of demand and supply have a bearing especially when the company has gone public and is already trading on the main stock exchange.
The shares of the company are subject to demand and supply in the market. When there is high demand for the company’s shares, the price of the shares will increase.
However, when there are negative prospects for the growth of the company in the future, the price would fall mainly due to the actions of short sellers.
The Measure of Stock Value
There are various elements that are used to measure the value of stocks. They are in the form of ratios.
Price to Earnings Ratio (P/E)
This is the most used ratio in stock valuation. It is commonly applied when there is a sudden increase in the price of stocks.
Basically, a stock may rise in value. However, if the rise in value does not translate to an increase in earnings, then it’s most probable that the stock will plummet eventually. The P/E ratio is what will tell you if the stock will remain up.
In most cases, the P/E is taken as the time at which the stock will take to pay back the investment. To illustrate: Let’s say a stock is trading at $10 per share with total earnings of $1 per share. The P/E is 10. Hence, it means that it will take 10 years for you to get your money back ceteris paribus.
Most investors choose stocks with higher P/E if they think that they will double their earnings annually. If they double their earnings, then the stock will continue to trade at the high P/E.
Price to Book Ratio (P/B)
The price to book ratio is typically the value that a company would have if it would be torn up and sold at present time. The assets of a company are what determine if the book value is good. These assets could include:
- Stock holdings
The best scenario here is when the P/B ratio is low. This will involve a lot of scrutiny on the part of the investor.
Price to Earnings Growth Ratio
Sometimes the P/E ratio is insufficient to determine the value of stocks. Thus, investors employ the PEG ratio which takes into account the historical growth rate of a company.
To get the PEG ratio, the P/E ratio is divided by the year over year rate of growth of the company’s earnings. Thus, the PEG ratio lets investors know how the standing of their stock relative to another stock.
Investors are better placed if they get a low PEG ratio as it translates to a stock having good earnings in the future.
Checking the dividend yield of stocks is also another way that investors value stocks. Investors normally divide the annual dividends of stocks by the stock prices and then calculate a percentage. However, the dividends have to be consistent in order to get an accurate valuation.
In conclusion, there are many tools that investors use to value stocks. The above methods can be used jointly to get an accurate valuation of stocks.