How Much to Pay for Stocks and Why
Determining how much one should pay for a stock is really wrapped up in what is called the stock’s valuation, and to understand stock valuation you have to understand the Price-Earnings Ratio or P/E. P/E is one of those very elusive things in investing that everyone talks about and tries to use, but few investors truly understand. Since P/E is easy to calculate (and shown on all stock tables) it can give investors a false sense of security if they do not understand exactly how P/E was calculated.
At its most basic P/E is the ratio of current stock price (which is easy to determine) to earnings (which are less obvious to determine). Since there are a variety of ways to calculate earnings it’s imperative the investor understand what method was used in the calculation of P/E. Savvy investors will always calculate P/E on their own (or using software) with a variety of earnings calculation methods to get the best understanding of the valuation of a stock.
Two common methods for calculating earnings are to use the sum of the past four quarters, or to use the estimates for next year. Since the past four quarters have already happened and the numbers are real, not estimates, this method is generally considered more accurate. But since past performance is no guarantee of future results, many investors pay close attention to estimated earnings that make use of complex mathematical models, and are calculated using sophisticated computer software.
P/E cannot tell you when to buy or sell a stock, but what it can tell you is if the stock is undervalued or overvalued and thus give you an indication of how much you should pay for a given stock. To make this determination investors use what is called the PEG ratio or Price-Earnings and Growth Ratio. The PEG ratio is calculated by dividing the P/E by the long-term growth rate. Ideally investors look to purchase stocks that have a PEG ratio as close to 1.0, but not less, as they can get. By doing this they have the most confidence that they paid the right price for the stock.