Valuation Metrics In Stock Trading

Stock trading has been around forever but sometimes it can be difficult to construct a bias for whether or not a given company is currently overvalued or undervalued.  One of the ways stock traders tackle this problem is to analyze the most commonly watched stock metrics.  Common examples here include price-to-earnings, return on investment, earnings per share, and compound annual growth rate.  Here we will look at what goes into each of these calculations to determine how they are used when generating new ideas for stock positions.

Price-to-Earnings Ratio (P/E)

 

The price-to-earnings ratio, or P/E ratio, compares the current stock price for a company with its earnings per share.  Specifically, we take the stock price and divide it by the per-share earnings number, and this metric gives stock investors a better idea of a comparative value than simple price data.  The P/E ratio is one of the most commonly watch stock metrics used to determine whether a stock is currently overvalued or undervalued compared to other stocks in the same industry. 

 

Imagine you are buying a new car.  One of the first things you would want to do is to compare the cost of that car to others in the same category.  If the car came with less features and cost more than some of the available alternatives, you would probably come to the conclusion that the car is not a good value on a comparative basis.  The P/E ratio works the same way in the stock world.  If a stock has a higher P/E than its competitors, it might be overvalued and ready to start dropping.  Exceptions could be made in choosing a stock with a comparatively high P/E if there are growth prospects that cannot be matched by other companies in the sector.  But, as a general rule, a lower P/E is supportive for buy positions while an above average P/E might signal a better opportunity to sell the stock.

 

Return On Investment (ROI)

 

Return On Investment (ROI) measures the amount of money gained or lost in an investment.  For example, an investor buys $100 in XYZ stock.  A year later, he sells that stock for $120.  This would imply a 20% ROI.  Here, we divide the total return by the initial investment cost to get the ROI. 

 

In practice, the ROI metric can be tricky because it is a number that is easy to skew or manipulate.  The company might not include all of the relevant costs in its ROI calculations, and this can make its managerial decisions appear to be more efficient and well-constructed than they actually are.  For this reason, it is generally not a good idea to base an investment decision on ROI alone.  Although it is still a useful tool in determining a company’s ability to generate revenue, and should be considered when you are looking to buy or sell a stock.

 

Earnings Per Share (EPS)

 

Earnings per share is a way of measuring corporate profits.  First, we deduct any dividends from the company’s total profit figure, and then divide by its total number of outstanding shares.  EPS is useful because it shows investors the amount of money a company earns for each tradable share.  A higher EPS is usually thought of as a positive but it is important for investors to remember that EPS does not include any information on expenses.  This can create some issues when using this metric on its own.

 

Let’s assume that Company A shows per-share earnings of $10, while Company B shows an EPS of $15.   At first glance, it would appear as though company B is the better investment.  But if Company B’s expenses are significant larger than what is seen at Company A, this might not be the case.  For these reasons, it is a good idea to watch EPS in conjunction with other commonly watched metrics (such as ROI) in order to get a sense of whether a given stock should be bought or sold. 

 

Compound Annual Growth Rate (CAGR)

 

Last, we look at the Compound Annual Growth Rate (CAGR), which calculates the average yearly rate of return that is seen in an investment.   The CAGR is a good way for investors to gain a broader perspective of a stock because it averages out the yearly growth an extended period of time.  This is better than looking at any one year in isolation because there could always be fluctuations in the rate of return that is seen in one year versus the others.  

 

In practice, the CAGR is helpful in designing a portfolio outlook.  Investors will often increase position sizes in assets that show a higher CAGR number, as this tends to improve overall returns.  Companies with higher CAGR numbers are also considered better for long term investments,  as they have posted a stronger and more stable performance over time.