Valuing Stocks Using EPS Part 2

In the first article, we discussed how to calculate a stock’s price. For review, you can compute the stock price by multiplying a company’s trailing twelve months (TTM) earnings by its pe-ratio. This is a very straight forward process, but it does have a few caveats that we will discuss in this article.

PE-Ratio

As we discussed in the previous article, the pe-ratio tells us how much we are willing to pay for each dollar of a company’s earnings. How do we determine the pe-ratio for a company? Luckily, a company’s pe-ratio is publically available, and it can be found on almost any financial website that shows a company’s stock price. Several examples include: nyse.com, nasdaq.com, finance.yahoo.com and google.com/finance.

A pe-ratio can be used to compare companies, but more importantly, it can be used to measure the market’s sensitivity to changes in a company’s earnings. What does that mean exactly? Well, companies that are considered high growth companies, such as start ups or technology companies, tend to have a higher pe-ratio. This is because people expect to make a higher return for investing in a riskier company. Let’s take a look at three different companies: Amazon, Apple, and Home Depot.

Sample PE-Ratios
Amazon (AMZN) Apple (AAPL) Home Depot (HD)
82 19 17

As a point of reference, the S&P 500 has a historical pe-ratio of 16. Notice how much greater Amazon’s ratio is than Apple and Home Depot in the table above. This is due to several factors. The obvious one is that Amazon is considered a technology company, and as we said earlier, technology companies historically tend to have a higher ratio. Apple could be considered a technology stock, but most professional analysts consider it a consumer goods company. Two other key factors differentiate Apple from Amazon. First, Amazon is a much younger company than either Apple, and its AWS product is still considered early in its growth cycle. Second, both Apple and Home Depot pay their shareholders a dividend. Paying a dividend returns money back to the shareholder which lowers the risk involved in owning the stock.

Which PE-Ratio do we use?

Everything we’ve computed to this point has used the trailing twelve months (TTM) data. Typically, TTM data is all we need, but wouldn’t it be nice to forecast future prices? That’s where the forward pe-ratio comes in handy. The forward pe-ratio represents expected earnings over the next twelve months. We’ll discuss how to calculate it in a future article, but for now, all we need to know is that the forward pe-ratio is typically listed with a company’s current pe-ratio. This is very convenient because it makes estimating the future share price of a company very quick and easy.

What’s next?

In the next article, we will combine everything we have learned so far, and we’ll use our new information to make more informed decisions. Some examples include: should you invest in a particular stock or is a stock over/under valued?