Knowing what is the nature of business is a necessity to be considered. This way you are aware how much a certain type of business cost fairly in the market. Market capitalization is known as the cost of acquiring a certain business. To calculate the cost, you need to multiply the current market price of the share against the number of outstanding shares.
Market Capitalization = Number of Outstanding Shares x Current Price per Share
So as not to overpay when buying a company, know the formula of market capitalization. Technology or dot com companies at certain point in the internet popularity possess similar if not higher cost compared with the blue chip companies pioneer in the market. A closer inspection revealed that some of the dot com companies profited only a single dollar. Considering this situation, there is a need to learn the formula of share price and earnings. Another method of knowing the cost we ought to pay for certain stock is to use the Price to Earning Ratio (P/E). Price / earnings ratio is commonly known as P/E or PFR; however, throughout the book, it is going to be the term P/E used. Take a look at the formula provided:
Price over earning per share, P/E= Market Value per Share / Earning per Share (EPS)
Example: Stock price of $10 with an EPS of $0.50 will be P/E equals 20. ($10 / $0.50)
To get an idea of how many times the earnings have been multiplied with the price you need to use the formula of P/E. This ratio usually increases together with the stock price or the other way around. For the ratio of a share with P/E at 30, the corresponding share price will be 30 times the present earning ability of the share. Taking into consideration that the EPS did not alter, for it would take around 30 years to equate the earnings with that of the buying price. For example, when P/E is 30, then EPS is about $1 per year, it will take at the least 30 years to get the $30 target.
Every analyst has his or her own explanation to the result of P/E. For you, how are you going to understand the P/E result? If there will be two companies both engage in the same nature of business. The P/E of Company A is 5 and Company B will have 20.
- Company A that has5 P/E in every $1 earning, means every stock cost $5 according to the market value.
- Company B that has 20 will be rated at $20 per $1 earning. To A analyst, the figure would be interpreted as Company A being the attractive one considering it is cheaper but generate the same earning rate. B analyst will conclude that Company B is the attractive one due to its higher P/E. in the latter case; the stock possesses higher value, which will convert to a potential return. What do you think is best, P/E that is low or high?
Keep in mind that once a stock has been evaluated and passed the ROE, EPs development rate and D/E, P/E that is lower, then it can be considered as one of the best stocks in the market. Always aim for the lowest P/E.
Keep in mind that in order to know the reliability of P/E:
- EPS should be stable, and never fluctuates often
- In addition, comparative study is effective only when applied to two similar business interests. A concrete example would be the utility companies who have low P/E but is quite stable within the industry. Technology on the other hand possess unparalleled development rate.
P/E = Market Value per Share /Earning per Share (EPS)
Only a company with a positive rate of earning per share will be able to provide significant function. For those companies who provide negative or zero value, it means the company is not worth picking unless it provides sufficient EPS. This only means that companies the shows 0 to negative value is not a potential company.
Analyst who prefers the safe calculation uses both the highest and lowest value in a given year. This is the most practical as this allows a reliable data averaging the 5-10 years operation of the company.
Averaging the P/E gives us a clear insight on the P/E range in the present against the P/E range in the past. If the P/E is below the mid range, there is no question of the stocks potential. Take the example below wherein the company existing for 10 years has 30 as its highest P/E and the lowest is 10 P/E.
Average P/E = (Average Highest P/E) + (Average Lowest P/E) / 2
= (30+ 10) / 2
= 20
For interested investor, if the P/E of the stocks in the market is about 22, then ideally you should invest later. To wait for the P/E to reach 20 is the best option to take.
To summarize, one factor alone will not provide sufficient data needed in order to determine the potential of a stock. At least consider the ROE, EPS development rate and D/E, and the P/E. In this way, a high P/E does not blind you, for there is the tendency that the stock is overvalued. It is difficult to know as to when the P/E will go down. For stocks that are undervalued, it takes years before its value return to its normal rate.