Evaluate An Investment In A Few Minutes Using These Powerful Metrics

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Outstanding Evaluation

When these two ratios are combined they become a powerful way to evaluate a business

There are lots of ways to trade in the stock market.  There are technical investors or chartists and fundamental investors who comb over the balance sheet with a magnifying glass looking for successful companies that are undervalued.  Then there are the combo traders who look at the charts for symbols and then go take a quick look at the balance sheet to determine a company’s financial strength.  All of these methods for trading have been proven to work.  There are quick and simple ways to evaluate a company though. if you overheard a hot tip during a water cooler conversation or if you are flipping through the channels and Cramer says buy this oil stock and then sounds a car horn these are two great quick metrics that you can use to understand how stocks are valued.  If you pick up these two quick ways to evaluate a company not only will you increase your financial literacy but you’ll have a lot of time to screen more stocks.

The Price to Earnings Ratio aka the P/E ratio

The P/E ratio is one of the most common ways to evaluate a company.  It is used to compare the financial performance of different companies, industries, and markets.  It is calculated by dividing the company’s current share price (found on Yahoo or Google Finance really easily) with the company’s earnings per share or EPS.  This can be found usually the summary page for a stock.  It is most commonly used when comparing stocks within an industry.  The P/E ratio is showing how many times earnings a company is trading so if Exxon’s P/E ratio is 11 and BP’s is 13.07 this tells you that Exxon might be undervalued compared to BP.  This tells us you are essentially paying $11 for every $1 of earnings if you purchase Exxon.  You should also consider the industry P/E ratio when evaluating whether a stock is over or under valued.   Companies with a high P/E are typically growth stocks because that tell s you investors value the company more because they are willing to pay more per dollar of earnings.

The Price to Earnings Growth Ratio aka PEG

The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year over year growth rate of earnings (net income).  The relationship between the P/E ratio and earnings growth tells a more complete story than the P/E ratio on it’s own.  The PEG ratio can use any growth rate duration.  It is usually from 1-5 years.  The growth rate can also be historic or forward looking.  You want to use the same assumptions when you are doing your analysis.

For a simple example let’s say you are interested in two stocks.  Your first pick is Big Al’s Grooming Company or BAG for short.  This company has been around for years sort of like where you dad gets his haircut but it has a P/E ratio of 10 and has  increased net income by 10% year over year for the last 10 years providing a very steady return.  The the second company you like is Becky’s Bikini Biergarten or BBB for short.  This is a restaurant chain that is two years old and just started trading on the stock market a week ago.  So the P/E ratio is going to be high at 40 because investors are very excited about the company and the net income has grown at 20% per year for the last two years.

You have BAG (The slow, steady, and reliable growing company):  P/E ratio is 10 divided by the earnings growth rate of 10 means you have a PEG ratio of 1

Then you have BBB (the exciting new upstart growing quickly) P/E ratio is 40 divided by the growth rate of 20 so your PEG ratio is 2.

What does this mean?  As a general rule of thumb a lower PEG means the stock is more undervalued.  What this is saying is that BBB is a young company and exciting but doesn’t have the growth rate to support the high valuation.  In conclusion the stock has been very hyped up.  If BBB had a growth rate of 40 or a lower P/E like around 20 then it would the same value for your buck as BAG.  It’s classic tortoise and the hare slow and steady does tend to win the race.

Conclusion

In this example the stocks are a mutually exclusive investment meaning you only have enough money to invest in one stock.   If you had enough money to invest in both stocks then this would be a diversification play.

Sometimes websites will have the PEG ratio listed in the statistics section.  If you use Google or Yahoo! given PEG ratio make sure you know what growth rate they are using.  This is a quick and simple way to evaluate two companies in a few minutes.


About Shaun Archer Tatum

Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.

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