The Key to Valuing Stocks Uncovered
The price of a security depends on a variety of factors from economic conditions to investor interpretation about a company and its products. Valuation of a companies' security takes a few considerations such as fundamental ratios; fundamental ratios will help to distinguish the good purchases from the bad. Also note a combination of technical analysis and fundamental analysis can be beneficial to use when determining both the value of a current security and a good time to buy. All information needed to value a given security can be found by searching Google Finance, and all ratios needed will already be computed; However, it is very useful to know what exactly each ratio means by first learning how to compute them and terms behind each ratio.
To start out using the fundamental valuation method, begin by analyzing book value which is one of the basic valuation measures. Book value is the value per share of a security as determined not by market conditions, but by the companies assets and liabilities. Book value is the amount of assets backing each share of common stock and is computed as shown below:
Book Value per share = (Tangible Assets - Total Liabilities - Preferred Stock) / Number of Common Shares Outstanding
The book value ratio of a given security should be compared to other companies in the same industry to determine a relative value; comparing multiple stocks together in the same or like industry.
EPS or earnings per share is yet another important ratio when determining a stocks value. EPS is effectively the earnings or amount of income the company generates for each share of common stock. Note: preferred dividends and common stock dividends are different. Preferred dividends will need to be subtracted from the EPS calculation because they are not payable to common stock shareholders.
Earnings Per Share = Net income - Preferred Dividends / Common Shares Outstanding
Earning per share is usually calculated two different ways because some companies will issue convertible bonds as well as issuing stock. We'll leave the convertible bond topic for another discussion, but you should know that the term convertible; in this sense, convertible means convertible to common stock. Convertible bond holders have the option to convert their bonds to shares of common stock, so a company that has issued convertible bonds can have an increase in shares of common stock without an increase in earnings at any time. When EPS is calculated including convertible bonds, it is referred to as fully diluted EPS and is calculated as shown below:
Fully Diluted Earnings Per Share = Net Income - Preferred Dividends / Common Shares Outstanding Including Convertible Shares
Current and potential investors also weigh decisions heavily on a companies dividend payout ratio. This ratio will show the percentage of earnings distributed to shareholders as dividends. Typically companies that are young will likely have a lower dividend payout ratio compared to companies that are much older. This is because younger companies will tend to reinvest earnings into the company for purposes of growth. Technology companies will also likely retain earnings because technology is a never ending evolutionary process. New technologies evolve every day into innovative products because companies retain their earnings, and they must do so to stay competitive in their respective market. The dividend payout ratio is computed as shown below:
Dividend Payout Ratio = Common Dividend Paid / Earnings Per Share
Current yield will also be very useful and is related to the dividend per share paid out to investors. Current yield will show the rate of return the dividend paid represents compared to the current market price of a given security. This is useful because investors can directly compare possible returns of various investments.
Current Yield = Annual Dividend per Common Share / Current Market Price
Stock prices depend on many fundamental variables such as a dividends paid, earnings, assets, and largely, investor expectations of future earnings and earnings growth. A given security often trades at prices above or below a securities current value or book value because of investors expectations. If the investors in a market believe a company is going to experience stellar earnings growth, the price of a security may be driven upwards do to increased demand for that security. So, a ratio to measure this expectation variable is the P/E ratio or price earnings ratio. This ratio relates the companies current stock price to the companies current earnings per share and is calculated as shown below:
Price Earnings Ratio = Market Price of the Stock / Earnings Per Share
Investors can use fundamental and technical methods of analysis to both determine a stocks value and a time to by a stock. Determining when to purchase can be tricky, however, with a few pieces of information an informed decision can be made.
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