As an investor it is vital that you find a stock at a good entry point. The best way to help you find a good entry point is to do some fundamental analysis and try to figure out what an appropriate valuation for the stock is. In order to incorporate valuation into a stock strategy you must first understand how to go about valuing a stock. There are numerous valuation ratios, but some of them are more important than others.
The 5 most important valuation ratios to understand:
- Price/earnings ratio - This is the most basic of the valuation ratios, but it is still a very viable valuation method that every investor needs to understand. Written as a formula the price/earnings ratio= price of the stock per share/earnings per share. Finding earnings per share information is simple these days as almost all financial sites have this information. The price/earnings ratio is a good valuation method to use when comparing valuation versus peers and valuations from a historical standpoint.
- PEG ratio (Price to earnings growth ratio) - This ratio is closely related to the first ratio, but it is slightly more dynamic and incorporates the estimated growth of a company. In the PEG ratio the formula uses the price/earnings ratio and then divides that number by the expected annual earnings per share growth rate. This is a great valuation method to use when considering whether a stock that is growing quickly is still a good value or not, but the method is also subject to objective guesses as to the growth rate.
- Price/cash flow ratio - This method measures the ability of a company to provide cash flow on a per share basis. The ratio is calculated by taking the stock price per share and dividing that by the operating cash flow per share. A top reason to use this method is it typically excludes possible accounting distortions that other investment ratios might not be able to exclude.
- Price/book value ratio - The book value of a company is a nice conservative valuation method that value investors and more traditional investors love to use. The price book value ratio is found by taking the stock price per share and dividing it by the shareholder’s equity per share. Over the years the book value has lost importance in many circles due to its undervaluing of modern asset types.
- Dividend Yield - While not every stock has a dividend, understanding that a dividend yield is essential in valuing a company is important. An investor can find the dividend yield of a stock by taking the annual dividend amount per share and dividing that by the stock price per share. A Dividend yielding stocks are typically more mature and more value related, as opposed to growth stocks which often yield nothing or almost nothing.
Understanding these valuation ratios will help the investor realize what kind of potential deal they are getting when they are ready to purchase an individual stock. Please understand that valuation methods aren’t the only thing you should consider when investing, but they are an important part of the puzzle.
Aaron K. Smith is a freelance writer with experience working in the mutual fund industry and writing about investing and the stock market.
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