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How to Value a Stock - P/E Ratio, P/S Ratio, and PEG Ratio - YouTube

Channel: The Motley Fool

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people look at stock prices all the time

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but how do you actually value a stock

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I'm Dylan Lewis from the motley fool in

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this FAQ we're gonna walk through some

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of the common ways that people value

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stocks and how you can use ez valuation

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tricks to know what you're buying one of

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the common approaches to valuing a

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company is looking at the p/e ratio this

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measures a company's current value

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against how much it actually earns an

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income and you can calculate it one of

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two ways first by either taking a

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company's market cap and dividing it by

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net income or dividing a company's

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current stock price by the company's

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earnings per share so if a company's

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stock trades for $50 and there are 10

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million shares outstanding is worth 500

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million dollars and we'll say for this

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example it has 25 million dollars in net

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income you get the p/e ratio by dividing

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500 million by 25 million or by dividing

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the share price of $50 by the earnings

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per share of $2.50 either way you get a

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p/e ratio of 20 you'll wind up with the

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same number either way because in the

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share price approach both numbers have

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already been divided by the total number

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of shares the company has outstanding so

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it's two different ways to the same

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place now you'll usually see the p/e

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ratio quoted two different ways trailing

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12 month or TTM which looks at the

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company's actual income over the past 12

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months or forward this approach takes an

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analyst estimate or a series of analyst

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estimates and looks at the earnings

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expectation for the company over the

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upcoming year and then uses that as the

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earnings figure if a company is growing

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its forward p/e ratio will always be

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smaller than its trailing 12-month PE

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ratio because more income is expected

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and the denominator will be larger if

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you see a p/e ratio out in the wild and

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it isn't specified which kind it is

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you can probably assume it's based on a

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company's trailing 12-month earnings the

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p/e ratio only works if there's an e or

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earnings so it's a helpful tool for

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companies that have income but it's

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totally useless if a company is not

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currently profitable that's why

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investors use another tool

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for unprofitable companies the p/e ratio

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would return a negative number which

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wouldn't really be very helpful

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so instead investors use a price to

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sales ratio this is a company's market

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cap divided by its total sales over the

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past 12 months high-growth software

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companies can have price to sales ratios

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of over 10 while more established

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businesses are usually in the mid to low

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single digits the PE and PS ratios are

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great because they allow you to

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normalize companies of different sizes

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and immediately get a sense of what

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investors are willing to pay for a piece

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of that company's earnings or revenue

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you can use these ratios to compare how

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a company stacks up to the overall stock

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market appears in their industry or

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itself relative to the past generally

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businesses that are posting high growth

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rates are going to have high priced

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earnings and price to sale ratios

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that's because investors expect that

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company to be considerably bigger in the

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future and they have bid up shares to

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reflect that that doesn't mean they're

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bad stocks to own it just means that

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people are expecting big growth to

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continue and if it doesn't shares could

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fall dramatically conversely stodgy old

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businesses in crawling industries tend

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to have lower p/e ratios because they

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aren't growing very quickly for them

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this year's earnings will probably look

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a lot like last year's the market isn't

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expecting much from stocks with low

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valuations so if the outlook gets worse

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they're less likely to take a huge hit

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but they're also less likely to give

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investors huge returns by now you've

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probably realized that these aren't very

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complicated calculations to do valuation

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sounds scary to new investors but really

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all you're trying to do with these

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numbers is get a sense of how much you

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have to pay for a dollar of earnings or

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revenue from a company and what the

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market expects from that company there's

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one more easy valuation metric you can

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look at to see how a company's valuation

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compares to the growth the company is

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posting and that's the PEG ratio the PEG

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ratio takes the value from a company's

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p/e ratio and then compares it to the

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company's earnings per share growth rate

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so to calculate it you first find the

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p/e ratio for a company and then divide

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it by the year-over-year earnings growth

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rate going back to our 500 million

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dollar business from before they have a

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p/e ratio of 20 let's say that they grew

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their earnings per share at 15% in 2019

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putting 20 over 15 we see that they have

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a PEG ratio of one point three three the

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generally accepted rule is that a PEG

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ratio of one represents a fair value

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while anything under one is cheap and

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anything

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is expensive compared to the growth the

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company is posting for all these ratios

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these rules aren't absolutes just

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guidelines as investors we're looking

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for quality companies with good business

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models and exciting growth prospects

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it's worth paying a premium for

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companies like that these metrics help

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us understand what the premium looks

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like and how it fits into the company's

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growth story there are more advanced

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ways of valuation they usually involve

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spreadsheets models and discounted cash

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flows don't worry about that kind of

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stuff right now if you have these basics

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down you'll be able to understand most

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conversations around how to value

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companies and most importantly be able

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to understand what you're buying when

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you decide to buy a stock and if you're

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looking for help with investing we've

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got a free starter kit for you

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covers everything from opening a

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brokerage account to buying your first

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stock and it comes with five great

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stocks to get you started you can get

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that for free over at fool.com slash of

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start that's gonna do it for this FAQ we

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want to know what stocks you're

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interested in and what questions you

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might have drop those down in the

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comment section below and be sure to hit

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that thumbs up button below to like the

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video and make sure to subscribe to get

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