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How to Calculate the Value of Stock With the Price to Earnings Ratio

Original post by Slav Fedorov of Demand Media

Price-to-earnings (P/E) ratio is a company’s stock price divided by current earnings per share (EPS). EPS is a company’s net earnings divided by the number of shares outstanding. When you multiply a stock’s EPS by its current P/E, you get the current stock price, or how much investors are currently willing to pay for a dollar of earnings. The lower the P/E, the cheaper the stock. Value investors often use a stock’s P/E to determine if a company is under- or overvalued -- or whether the stock is a good buy at the current price.

Contents

Step 1

Obtain a company’s long-term EPS growth rate from a financial portal such as Yahoo! Finance or MSN Money for the past three or five years.

Step 2

Calculate the current EPS growth rate by comparing the EPS for the last two or three quarters to the same quarters last year.

Step 3

Compare the EPS growth with the current P/E. The current P/E can be obtained from an extended quote provided by Yahoo! Finance or a similar portal. The rule of thumb is that a fully valued stock should have a P/E that equals its earnings growth rate. If the P/E is below the EPS growth rate, the stock is undervalued; if the P/E is above the EPS rate, the stock is overvalued.

Step 4

Assume that the stock you are researching is fully valued -- that is, its EPS growth rate equals its P/E. Substitute the EPS growth rate for the current P/E and multiply it by the current earnings per share (which can also be obtained from a financial portal) to arrive at the stock’s potential value. If the figure is higher than the current stock price, the stock is undervalued; if the figure is lower than the current stock price, the stock is overvalued.


                   

Tips & Warnings

  • Use historical P/Es instead of EPS growth rate in your calculations to see if a stock is over- or undervalued by historical standards. You can obtain historical P/Es from a stock data service provider such as Value Line or MarketSmith, a service of Investor’s Business Daily.

Resources

References

  • “One Up on Wall Street”; Peter Lynch; 2000

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.


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