What Is a Fair Price To Pay For My Stock?
Last week, I had a great conversation with Reggie while flying home from a conference. We had talked about a few different dividend stocks, when Reggie admitted that he had no idea how to estimate a “fair price” for investing in shares of stock.
Reggie is an expert in his field of workflow automation. He explained a few solutions he engineered for a client, and the details made my head spin. But without a finance background, he didn’t know much about researching stocks for his investment account.
The conversation reminded me of how important it is to have a grasp of the basics when it comes to investing. This is a lot like an athlete knowing the basics of a golf swing, a jump shot, or a blocking technique.
So over the next few days I thought I would share a few of the basics that every investor should know. If you’re an advanced investor, this may be a familiar discussion. But just like in athletics, sometimes revisiting basic fundamentals is helpful even to the most skilled and experienced player.
Editor’s Note: This is part I in a multi-part series on basic investing principles. See also:
Stay tuned for more in this series coming soon!
Measuring Value for Shares of Stock
What if I told you that I would sell you my car for $10,000? Would you buy it?
It’s a silly question, right? You have no idea what kind of car I drive, how old my car is, whether it is in good shape or not, or what the resale value might be.
In short, you don’t have nearly enough information to make a decision about my car.
Unfortunately, too many investors make a decision to buy shares of stock with a similar lack of information.
What would you be willing to pay for shares of Coca Cola (KO), shares of Home Depot (HD) or shares of Walt Disney (DIS)?
Yes, all three of these are good companies with strong management teams, and a loyal customer base.
But without knowing more about what you are getting when buying shares, you can’t possibly know what a “fair price” for these shares would be.
Today, I want to show you four different measures that investors use to determine how much to pay for shares of stock.
Remember, when you buy shares of stock, you’re actually buying a small piece of that company. So when you own shares of KO, you technically own a fraction of the Coca Cola company. So now, the question you should be asking, is how much is this fraction of a company worth?
My hope is that by learning these different measures, you will be able to make smart choices when buying shares of stock. This way, you’ll always get a great deal when you invest!
Measure #1: The Price / Earnings Ratio
The first measure we’re going to cover today is the price / earnings ratio. This is one of the most popular ways for evaluating what you’re getting when you buy shares of an individual company.
Let’s assume you’re interested in investing in shares of Coca Cola (KO).
Most professional investors will decide what they’re willing to pay for these shares, based on how much profit (or earnings) the company generates. The more profit Coca Cola makes, the more investors should be willing to pay for the stock.
A quick internet search will reveal that Coca Cola generates earnings of $7.62 billion per year. That’s a tremendous amount of profit. But it doesn’t tell you much about the fraction of the company you own when you buy a share of KO.
To put the profit number into context, analysts divide the total profit by the number of shares of KO that are outstanding. In this case, there are 4.32 billion shares of KO outstanding. So if you divide $7.62 billion in earnings by 4.32 billion shares, you get “earnings per share” of roughly $1.76.
Earnings Per Share (EPS) = total company earnings, divided by total shares outstanding
Now that you know how much Coca Cola earns for every share, you know what you’re “getting” when you buy one share of KO. Next, let’s look at the price of those shares and see if you’re getting a good deal or not.
As I write this post in September of 2016, the price of KO is near $42.75 per share.
One of the most popular ways to value shares of KO, would be to divide the price of shares of KO by the amount of earnings per share. In this case, we would divide $42.75 per share by $1.76 of earnings. This gives us a Price / Earnings ratio (or PE) of 24.3.
Price Earnings Ratio (PE) = Price per share, divided by EPS
Put another way, if you buy shares of KO at this price, you’re paying $24.30 for every dollar of earnings generated by Coca Cola.
Measure #2: The Price / Sales Ratio
Using a stock’s PE is a great way to analyze a mature, profitable company. But what about companies that haven’t yet turned a profit? Or companies that have special circumstances that are temporarily distorting profit levels?
In this case, you might consider using a Price to Sales Ratio.
This method of valuing a stock is not as popular as the standard PE ratio. But the measure can be especially helpful for new companies in early stages of growth.
Similar to the PE method, we’ll need to take total annual sales for the company and divide by the number of shares outstanding. This gives us the amount of sales (or revenue) per share.
Next, we divide the price for each share of stock by the total sales per share.
Price Sales Ratio (PS) = Price per share, divided by sales per share
In other words, if a stock has a price to sales ratio of 5, it means we must pay $5 for every dollar of sales that the company generates.
Measure #3: The Price / Book Ratio
A third measure that investors often consider is the price / book ratio. This statistic gives us a picture of how much a company is worth “on paper,” and how close the stock price is to this accounting-based metric.
The “book value” of a company measures how much a company’s assets are worth, after subtracting the company’s liabilities or debts. This metric is especially helpful for evaluating stocks of companies that have large amounts of physical assets.
The first step for calculating this measure is to find the book value of the company in question. You can usually find this in a company’s annual report, or on a financial website such as Yahoo Finance or MarketWatch.
Again, the book value of a company is the sum of its assets, less debt or other liabilities owed by the company.
Once you have the total book value for a company, we then divide this value by the number of shares outstanding. This gives you the book value per share for the stock you’re analyzing.
The final step is to divide the stock price by the book value per share.
Price / Book Value = Price per share, divided by Book Value per share
If your stock has a price / book measure above 1.0, it means you are paying a premium for the company’s assets. And if it is below 1.0, this means that you’re buying a fraction of the company for a discount compared to the accounting value of this company.
It’s helpful to remember, that there may be very good reasons why shares trade at a premium or discount. And there are various different ways to determine book value (based on different accounting methods).
Measure #4: Dividend Yield
One final measure for evaluating shares of stock is the dividend yield.
Not all companies pay a dividend. But this is an important way for companies to pay out earnings to the owners. (Remember, as a shareholder that’s you!)
Let’s go back to shares of KO for our example.
Coca Cola currently pays shareholders $0.35 per share, once each quarter. So in a given year, shareholders can expect to receive $1.40 in dividends.
You can measure a company’s yield by dividing the dividend payment by the price you must pay for shares of stock.
Dividend Yield = Annual dividends per share, divided by share price
Shares of KO are currently trading near $42.75. So if we divide the $1.40 in annual dividends by the $42.75 share price, we get a dividend yield of 3.27%. In other words, if you invest in shares of KO, you can expect to receive dividend income of 3.27% each year.
A company’s dividend yield can be especially helpful when comparing to other stocks you might be interested in investing in. You can use the dividend yield to quickly determine which stocks will pay you the most. Also, you can use dividend yields to estimate what kind of cash flow you can expect from your investment portfolio.
Next Up: Putting These Measures Into Context
In our next installment, we’ll talk about how to use these measures to make better investment decisions.
Of course there are a lot of nuances when picking individual stocks. But understanding the basics can put you well ahead of other investors when choosing which stocks to invest in, and what price you’re wiling to pay.
If you’re interested in learning more about how professional investors make decisions on which stocks to buy, I would recommend reading Market Wizards by Jack Schwager. This collection of interviews gives you an inside look at some of the decisions the very best investors in history have made.
Market Wizards is just one of the books on my “top ten” list of investment books.
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