How to value a company’s stock
Earnings provide the basis of one of the major measures of a stock’s individual value. Investors often use a statistic known as the Price-to-Earnings (P/E) ratio to help assess how expensive a stock is relative to the rest of the market. In other words, it is the ratio of the current price of a stock compared to the company’s earnings. If a stock is trading at $30 per share and the company’s annual earnings are $2/share, the P/E ratio is 15.
P/E ratios are often expressed in two ways, trailing and forward. Trailing P/E reflects how the current stock price measures up against earnings over the previous 12 months. For example, in mid-September 2023, the P/E ratio for one of largest stocks in the U.S. market, Microsoft Corporation (MSFT), was 34.72. That reflected its current share price in relation to earnings generated over the previous 12 months. A second way to assess valuation is by looking at P/E ratios reflecting anticipated (forward) earnings over the next 12 months. On that basis, the P/E ratio for Microsoft stock is slightly lower, at 30.30.3 P/E ratios are generally expected to be lower when based on forward earnings rather than on trailing earnings, as companies typically are expected to be increasingly profitable over time.
Haworth notes that P/E ratio is just one measure of a stock’s performance. “We look at a variety of valuation assessments, including sales growth and book value growth, which is essentially a way of estimating the liquidation value of a company.” Other factors would include a company’s cash flow and a stock’s dividend yield.
When trying to assess which of two stocks offer the best investment opportunity based on their P/E ratios, it’s important to recognize that it’s not always an “apples-to-apples” comparison. “There can be variations in the expectations for different kinds of stocks,” says Haworth. “Determining fair value has a lot to do with the underlying growth rate of the industry in which the company competes.” Some stocks may be viewed with a longer lens, as investors demonstrate a willingness to bid up prices based not on current earnings, but on expectations of future profitability. “This tends to be the case, for example, with stocks that invest in new technology that may not have an immediate payoff but offer the potential of future strong earnings if they succeed,” says Haworth. “Other stocks may have lower P/E multiples, but those companies generate steadier earnings, so the payoff on the investment needs to happen in a more compressed timeframe.”