Valuation means assigning a ''proper'' value, or price, to a stock. The quote marks around ''proper'' remind us that while the word implies that there is a single ''correct'' price, in fact the concept is theoretical. Valuation is nevertheless an important guide to what price at which to buy or sell a stock. If you pay too much for a stockmore than it is ''worth''your returns will suffer forever after.
Many large-scale institutional investorsmutual funds, brokerages, hedge fundshave developed complex mathematical models for determining a stocks ''proper'' price. The individual investor needs to go a different route.
Fortunately, a second method exists which is just as good, easy to understand, and readily available. This second method uses what are called valuation ratios.
Valuation ratios divide the stocks current price (P) by quantifiable aspects of its business: its earnings, its revenue, its book value, and so on. Each ratio is then compared to historical norms to tell whether the stock is fairly priced at its current price P.
Here are some common valuation ratios that the Sensible Stock Investor uses:
--P/E, or price-to-earnings ratio. This compares the stocks price to the companys reported earnings. This is the famous ''multiple'' that one often hears about.
--P/S, or price-to-sales ratio, which compares the stocks price to the companys revenue.
--P/B, or price-to-book ratio, which compares the stocks price to the companys book value (as computed by accepted accounting principles).
--PEG, which is the P/E ratio divided by the earnings growth rate of the company.
--P/CF, or price-to-cashflow, which compares the stocks price to its annual flow of cash.
Happily, all of these valuation ratios, plus others, are available for free on virtually all financial Web sites. They are usually current to the very day. If you know the historical benchmarks, it is easy to interpret each ratio as indicating whether, like Goldilocks porridge, a stocks price is too hot, too cold, or just about right.
If you would like to learn about a comprehensive stock investment approach that that uses the same strategies reflected in this article, please consider purchasing Sensible Stock Investing: How to Pick, Value, and Manage Stocks. To learn more about this investment system designed for the individual investor, visit http://www.SensibleStocks.com for more information, or to purchase the book.