I’m convinced that most people have no clue how to value a company. I can’t tell you how many times I have overheard somebody talking about the price of a stock that is $38 per share and ask “do you think it will go to $40?”.
Here’s the blunt answer to that question – the price per share does not matter. What matters is the company’s valuation.
Every company can decide how many shares to issue for their company. If a business is worth $10,000 and has 200 shares, each share of stock is worth $50. The company could decide tomorrow to do a reverse split, and have only 100 shares. Doing so doubles the price per share to $100!
Unfortunately, the business is still only worth $10,000.
There are many terms to learn before you start investing. To help with this, we’re going to use valuation metrics for Alphabet, the parent company of Google. This screenshot is courtesy of FinViz, which is our favorite free tool for analyzing stocks.
We also put together a quick accounting lesson using a lemonade stand, feel free to reference this if you have any questions about the accounting terms we’re using, such as book value.
Alphabet Share Price: $1,054.14
Market Capitalization (Often Called Market Cap)
Market capitalization is the total value of a company’s common equity, or the value of all the shares outstanding. When you calculate how to value a company, you need to start with their market cap.
Alphabet has a Market Cap of $703 billion. We can calculate this ourselves by multiplying the share price ($1,054.14) with the number of shares (667 million).
Price to Earnings (P/E) Ratio
P/E ratio calculates the price of a share of stock compared to the last 12 months of profit per share. This is the premium the market is willing to pay on your earnings – the higher the P/E Ratio, the more of a premium the market is paying on your earnings.
For Alphabet, the market is paying $58.70 for each dollar of net income last year. This is a massive premium compared to the average P/E Ratio for the general market, which is right around 22 as of 2018. A number as high as this means that the company is either growing incredibly fast, or that there may be some one-time occurrences that effected their earnings. Examples could be selling a subsidiary for a gain, or a one-time legal expense.
Forward P/E Ratio
Forward P/E Ratios calculate the price of a share of stock compared to the next 12 months of profit per share. Since investments should be about future earnings, Forward P/E ratios should be given more weight than the P/E Ratio.
In our example, the Forward P/E for Alphabet is 21.70, which is right in line with the general market. A great sanity check for investments is to ask whether a company will outperform the general market. If you believe that the company will, and it is trading at or below the general market, you’re buying this company at a great price.
Price to Book (P/B) Ratio
Price to Book is the price of a company compared to the amount of assets available to shareholders. In our accounting lesson, our Lemonade Stand has a Book Value (or Owner’s Equity) of $5,000.
For Alphabet, they have a book value per share of $219.55, and the company’s price to book ratio is 4.80. Technology companies typically have high price to book values, so make sure you compare companies to similar industries.
Dividend Yield
Dividends are cash distributions from the company to shareholders. In general, companies should only return cash to shareholders if they don’t have anything else better to do with the money. While dividends are a great source of income, it’s important to keep an eye on how much the company is paying out. If the dividends are too high relative to a company’s income, they may be in financial distress in the future.
Alphabet doesn’t pay any dividends since they are still growing at a rapid pace. They do buyback shares, which is another great way to return capital to shareholders. Warren Buffett actually prefers buybacks since they are cash free.
How to Value a Company – The Bottom Line
Knowing how to value a company will help you make much better investment decisions. There is a lot more to focus on than simply the share price. In fact, I recommend forgetting the share price, and focus on the company’s value.
Low values tell us that the company is either expected to perform poorly in the future, or that the stock could be undervalued. If a company has a low valuation relative to their income or assets, you will have a high margin of safety with your investment. Conversely, companies with sky high valuations could plummet at the first sign of trouble.
Many value investors have made a great living by finding low valued companies that were trading at a great discount. Warren Buffett is certainly the most famous, but there are many more who have succeeded with this as well.
Regardless of how you decide to invest, we hope this gives you a better idea of how to value a company. The best way to maximize your return is to invest at a low price, and this shows you how to determine the price you’re paying for a stock.