One of the most simple ways for YOU to value a company
What does a share price of $6 or $4 tell you? Surprisingly, not much.
A share price on its own is fairly meaningless when it comes to telling you about the valuation of a company. A share price is the price of a single share of a company.
A company’s share price is determined by what an investor (you) is willing to pay for it, and what price an investor is willing to sell it for. Therefore a share price is dependent on what the future expectations are for that company. High expectations (or a more positive outlook) means more people will demand the shares, driving the price of those shares up, and vice versa if more people wish to sell the shares.
With that being said, a company value (and in turn it’s share price) is derived from the future earnings and cash flows discounted back to today’s date.
A stocks value (which is a figure derived from expectation about future performance of the business), is not always the same as its current price it is trading at in the stock market.
An investor would buy a share because it believes the share is undervalued and an investor would sell a share if they believed it was overvalued. An investor (whether that be a professional or a DIY investor) ultimately aims to assign values to stocks because it helps them decide if they want to buy them or sell them.
But how do you assign a value to a company? There are multiple ways to determine the value of a stock or company. The most common way is to calculate the company price-to-earnings (P/E) ratio. The P/E ratio is just the company stock price divided by its earnings per share (EPS), and it’s EPS is just its profits divided by the number of shares it has offered to the public.
For example, say Fletcher Building (FBU) earned $10 million of profit in 2021. It also has 10 million shares available so it’s EPS in 2021 is $1.00. It’s share price today is $15.00. With all this information, we can figure out the PE ratio of FBU. The P/E ratio for 2021 is 15x (the price of $15.00 divided by the EPS of $1.00).
A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value. A high P/E suggests the stock may be overvalued.
A P/E ratio in isolation only tells us so much too. This is why it is always good to compare a company’s P/E ratio to other companies. You can compare it to other companies in the same industry (e.g other healthcare companies or retail companies) or to other companies in the same country (e.g an Australian company P/E vs the ASX 200 Index P/E) or to companies you think are similar in some way. Let’s look at our FBU example; we could compare FBU’s P/E with other building products companies.
We do this to see if we are ‘overpaying’ or ‘underpaying’ for FBU. If FBU’s P/E is a lot higher than other building products companies P/E ratios, then you could be overpaying. And if FBU’s P/E ratio was lower than other building product companies P/E’s, then you could be getting a bargain.
It’s just like buying a car. For example, if you decided that you wanted to buy a Nissan Leaf, you might jump on TradeMe and see if you can find one within your price range. If you found that someone had listed a 2015 Nissan Leaf for $20,000 you wouldn’t necessarily just take the sellers opinion on how much they think the car is worth. You would most likely do your research and compare that to other similar listings, to make sure that similar cars, bought in a similar year and on a similar condition - were worth the same amount.
You can find all the information to calculate a company’s P/E ratio by heading to the Investor Relations (IR) section of their website. Most companies, with shares available to the public, will have an IR section of their website. Here you will find one of the most important documents for investors the Annual Report. This is a great document that gives you a comprehensive view of the company you are about to invest in.