Book Value
There are a number of ways to value a company. One option, popular among some mutual fund managers, is to consider a company's intrinsic value, which takes into account all the tangible and intangible value that a company possesses, including ites perceived worth. Another is to consider what a potential private buyer might bid for the company - lock, stock, and barrel - to buy it out.
But perhaps the most popular way to assess a company's value, aside from considering its market cap, is to consider its book value. Book value tries to assess what a company is really worth by weighing all of the assets on its balance sheet, or books.
To figure out a company's book value, follow this simple formula:
Total assets - Intangible assets- Liabilities = Total net assets = Book value
A company's book value reflects what the company is literally worth, based on things it owns, including its inventory, properties, and facilities. At times, a business's book value and market value could be wildly divergent, depending on whether a stock is in favor or out of favor among investors.
Valuations
Knowing a company's book value can come in handy when assessing whether a stock is trading at a reasonable or fair price. For instance, investors may feel hesitant to purchase a stock whose price per share is 10 times its book value per share. They may feel more comfortable investing in a stock that is trading at only around 4 times its book value per share. To figure out a company's price-to-book ratio, or P/B ratio, consider the following formula:
Total net assets (or Book value)/Total shares outstanding = Book value per share
Stock price/Book value per share = Price-to-book ratio
This would be one way to judge a company's valuation, a term that refers to the cheapness or priceyness of a stock. Depending on the company and the industry, you can get a fairly reasonable sense of whether a stock is over- or undervalued based on its price-to-book ratio. For example, you can go to Websites such as http://www.morningstar.com/ to find out the P/B ratio of a specific stock along with the P/B ratio of other companies in that industry. If your stock's price-to-book ratio is lower than that of its peers, that's one clue that it probably is undervalued.
Another so-called valuation measure is to conisder a stock's price relative to the earnings generated by the underlying company. This is referred to as a stock's price-to-earnings ratio or P/E ratio. To figure out a company's P/E ratio, use the following formulas:
Earnings/Total shares outstanding = Earnings per share (EPS)
Stock price/Earnings per share = Price-to-earnings ratio
It's important to keep in mind that a stock has more than one P/E ratio. Some investors, for example, believe it's important to gauage a stock's price versus its forward earnings. So, assuming that Smith Phone is expected to earn $1.50 a share over the next 4 quarters, its forward P/E, based on estimated earnings for the next 12 months, may be 16.67 (assume price per share is $25, i.e. $25/$1.50=16.67).
Other investors hate using estimates, so they focus instead on actual earnings numbers. So let's say that over the prior 12 months Smith Phone earned $0.95 per share. Its trailing P/E, then, would be 26.3 (i.e.$25/$0.95=26.3).
There is yet another type of price-to-earnings ratio that is commonly used on Wall Street. And that is the P/E ratio that relies not just on past earnings but 10 years' worth of historic earnings that have been averaged. This method of valuating a company was popularized by Yale economist Robert Shiller, who is famous for having predicted the stock market crash in 2000 and the decline in real estate shortly thereafter. Why do many investors favor the 10-year averaged P/E? By averaging out profits over a lengthy period of time, this method smooths out any anomalies that may take place in earnings during booms and busts. To find out the current 10-year averaged P/E, as well as historic figures, using this method, you can go to Professor Shiller's Website: www.econ.yale.edu/~shiller/data.htm.
Regardless of which P/E ratio you favor, make sure you're comparing apples to apples.
Why is it important to even be looking at P/E ratios in the first place? For starters, it's always good to know if you're overpaying for a stock, or if you're getting your shares at bargin prices.
But the single best reason to pay attention to a stock's price-to-earnings ratio is that this gauge is to often a good predictor of how well equities will perform over time. Indeed, if you look at the market's past performance based on its 10-year average P/E ratios, you will find that the higher the market's P/E ratio, the greater the likelihood that your investments will deliver lower-than-average gains. Conversely, the lower the market's P/E ratio, the greater the anticipated returns. (Lower P/E ratio is better)
