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A $20 stock can be expensive and a $900 stock can be cheap. Here is how to judge a price with a few simple numbers: P/E, growth and what the price already expects.
The first trap is looking at the share price. A company trading at $20 is not cheaper than one at $900. The price depends on how many shares exist, which is an arbitrary choice. What matters is what you get for your money: a slice of the company's profits.
So the real question is never “is $900 a lot?” but “how much am I paying for each dollar this company earns, and how fast will that grow?”
The price-to-earnings ratio (P/E) divides the share price by the profit per share over the last year. A P/E of 20 means you pay $20 for every $1 of yearly profit, or, put differently, 20 years of today's profits.
Over long periods, the US stock market has often traded somewhere between 15 and 20 times earnings, though it has spent long stretches above and below. A P/E far above that means investors expect a lot of growth. A P/E far below can mean a bargain, or a company in trouble.
A P/E is meaningless when profits are tiny or negative. For young companies that don't make money yet, investors look at sales or future profit estimates instead.
A P/E only makes sense next to something else. Compare a company with its own history (is it pricier than usual?) and with similar companies (is it pricier than its rivals?). A software company and a bank naturally trade at very different multiples.
Also check the forward P/E, which uses expected profits for the next year. If the forward P/E is much lower than the current one, analysts expect profits to grow quickly.
Every price hides an assumption about the future. A company at 60 times earnings must grow its profits very fast for years just to justify today's price. If growth comes in only “good” instead of “spectacular”, the stock can fall even while the business does well.
This is the most useful question you can ask: what has to go right for this price to make sense? If the answer is “everything, for ten years”, the stock is expensive, however great the company is.
A cheap stock with lots of debt, shrinking sales or no cash flow can stay cheap or get cheaper. Before calling something a bargain, check that the company earns real cash, isn't drowning in debt and isn't losing customers.
Finex's Financial Health Scanner looks at debt, liquidity, margins and cash flow, and its Fair Value Calculator estimates a range of values from earnings, cash flow and growth, and shows the growth already priced in.
1. Ignore the share price; look at market cap and P/E. 2. Compare the P/E with the company's history and its peers. 3. Ask what growth the price assumes. 4. Check debt and cash flow. 5. Think in ranges, not a single “true” value.
No method predicts the future. The goal is to avoid overpaying by mistake and to understand the bet you are making.
Try it: Stock Fair Value Calculator