Market Evaluation of a Company

Now that you have an idea how financially healthy a company is, it's time to look at the current stock price and if this is on par with the financials in the books. If a company is financially healthy, that does not mean the stock is trading for a good price. Stocks can trade:

  • Below intrinsic value (undervalued)
  • At intrinsic value
  • Above intrinsic value (overvalued)

There are a few important ratios that look at the current stock price compared to the intrinsic value of the company:

  • Price to earnings ratio (PE ratio)
  • Price to book ratio

Price to earnings ratio

The PE ratio is a very commonly used ratio to determine the value of a company by comparing the current stock price relative to its earnings per share (EPS). Before we can calculate the PE ratio we need to know the EPS. EPS is calculated as follows:

  • EPS = (net profit - preferred dividends) / end of period outstanding shares
  • Net profit = revenue - expenses
  • Outstanding shares can be found in the balance sheet

To calculate the PE ratio:

  • PE ratio = market value per share / earning per share

Where the market value per share is simply the current stock price. The PE value helps investors to determine if the current stock price is under or overvalued. It also projects future growth. In general, a high PE ratio can’t be determined by the ratio itself. That’s why PE ratios can only be compared to other companies within the same industrie (but not across industries).

In general, a higher PE ratio means higher future growth. If the PE ratio is too high, then investors expect way too much future growth the company can never fulfill. This is most likely to happen in faster moving companies like tech companies or automobile companies like Tesla. These are hot and booming markets where investors expect much future growth driven by new technology (electric cars). When looking at the current MRQ (most recent quarter) PE ratio of Tesla ( jan. 2021) it's about 247 while the average in the industry is only 6. That might be a clue that Tesla is trading for way too high prices compared to their current assets and is more based on future growth.

Price to book ratio

The price to book ratio is another way to determine if a stock is under or overvalued. The PB ratio is used to compare the current stock price to its book value. In other words, the PB ratio is used to compare all the assets in relation to the stock price. The book value is calculated as follows:

  • Book value = all assets - liabilities

The PB ratio is then calculated as follows:

  • PB ratio = stock price / book value

If the PB ratio is greater than 1 that means the stock is trading for a higher price than the intrinsic value of the company. Meaning, you pay more than what the company is worth. Although future growth is hard to measure. A higher PB ratio than 1 also means that you are last in line (shareholders get paid last when a company defaults) when the company goes bankrupt for whatever reason. 

Book value is limited for companies that offer services because there are not many tangible assets on the balance sheet compared to large manufacturing companies. It also does not take brand names, patents and other things in consideration. 

Market evaluation How to calculate How to interpret
P/E ratio Market value per share / earning per share P/E ratio depends on the market. Overall higher rates should be treated with caution
Price to book ratio Stock price / book value Any value under 1 is considered a good value

I discussed the most important ratios you can use to determine the health of a company. That does not mean these are the only ones. There are many, many other ratios out there you can use. You can also tweak ratios to include or exclude certain aspects. They are just small tools to help you evaluate the health of a company. As these ratios might work right now, that does not mean you can always use them reliably in the future.

Key Concepts:

  • Market evaluation is the process of checking if the current stock price is overvalued, undervalued or on par with the intrinsic value of the company (based on fundamentals).
  • The price to earnings ratio is a very commonly used ratio to determine the value of a company by comparing the current stock price relative to its earnings per share (EPS).
  • The price to book ratio is used to compare all the assets in relation to the stock price.
  • You can only compare ratios between companies from the same industry.


Chapters: The Ultimate Investing Guide

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