If you’re interested in learning more about how we use analysis to construct a portfolio or how current market conditions affect our positioning – check out our recent video with Sam & Steve
How is a stock priced?
We were recently asked by a client how we make stock selections or decide to move forward into a position and it got us thinking. We’re so used to evaluating stocks in our day-to-day decision-making, that we forget it can be a little complex.
There’s A LOT of different strategies and theories that exist to help investors determine the value of a stock (and no, most of the time, this doesn’t include listening to news headlines). And a lot of factors on top of strategies to consider, even some without quantitative values. We’re typically looking at new positions with many valuation techniques, trying to paint as accurate a picture as possible for our interpretation.
But, for discussions sake, we’re just going to spend a few minutes going through more general approaches investors employ when valuing a stock.
Let’s start at the beginning – what’s a stock and why do we value stocks?
A stock is used to represent ownership in a corporation – with each share being an appropriated percentage of ownership.
Why we value stocks is pretty straightforward: In active investing, evaluating a stock’s “worth” helps govern when we buy and sell, and what we buy and sell. We compare what we’ve determined it’s inherent value to be against it’s market value or price, then decide if it’s a worthwhile investment and in alignment with our desired outcomes.
There will always be a subjective element to valuing stocks, and everybody reads the tea leaves differently – but here’s some of the different tools we use for analyzing a stock’s value:
Fundamental Analysis Earnings-per-Share (EPS): This is the company’s after-tax income divided by the number of shares.
Dividend Yield: This is annual dividend divided by the share price. This is used to calculate the dividend-only return of a stock position.
Price-to-Book Ratio (P/B): This is a company’s “book” value per share if everything were sold off today, essentially the company’s net asset value. This is market share price divided by book value per share (total shareholder equity minus preferred equity then divided by total outstanding shares)
Price-to-Earnings (P/E) Ratio: The gold standard of investing metrics. This is the company’s stock price divided by it’s EPS. What you do with this number is open for interpretation, and your goals will probably have a big impact.
If you’re value investing – a low ratio can essentially be interpreted as being undervalued in the market – or a stock that’s “on sale.” For growth investing, a higher ratio might indicate that investors are willing to pay more anticipating coming earnings and rapid growth.
A couple other metrics for considering a company’s stock value:
Current Ratio: This is the company’s assets divided by it’s liabilities. A higher ratio indicates a company is better able to pay it’s debts.
Debt-to-Equity Ratio: Just like we have debt-to-equity ratios when determining our credit, companies measure debt to equity the same way. A high debt/equity ratio means the company is leveraged and might be more vulnerable in downturns.
Technical analysis typically involves a lot of charts to analyze movements in price and patterns in volume and price changes over periods of time. Moving averages over time spans – like the 50-day and 200-day moving averages and trade volume are some favorites among charters.
Investors use some or all of these strategies and metrics (and more) to assess a stock’s value and conclude if it’s a reasonable purchase for what they’re trying to accomplish.
The information provided in this material is for general information only and are not intended to provide specific advice or recommendations for any individual.