Stocks: Valuations

Oscar Wilde famously defined a cynic as "a man who knows the price of everything and the value of nothing." When it comes to stock valuations, investors can be forgiven for fitting Wilde's definition of cynical. In the stock market, there are countless ways to attach a value to a stock, but -- to quote screenwriter William Goldman's mantra about Hollywood -- "nobody knows anything."

It is a testimony to the elusive nature of stock valuations that so many people have come up with so many different ways to value a stock, the two most prominent categories being technical analysis and fundamental analysis, which we'll talk about in a bit. For the sake of offering a starting point, the value of a stock is what participants are willing to pay for it based on current conditions, the company's growth prospects and investor perceptions. Most importantly: a stock's value is in constant flux.

Technical analysis involves using stock charts to track historical patterns of investing in an attempt to glean how a stock will perform going forward. The practitioners of technical analysis, called chartists, aren't overly concerned with a company's fundamentals in determining value. It's more about group psychology: They want to detect patterns of how market participants have behaved and apply it to stocks in the present.

Conversely, fundamental analysis involves looking at a company's "fundamentals," such as earnings and revenue growth, market share, dividend payouts and business plans in an effort to determine a stock's intrinsic value. The majority of Wall Streeters use fundamental analyses in some form, even though how to evaluate fundamentals is an ever-evolving art form.

One common way of analyzing a company's fundamentals to determine valuation is the price-to-earnings multiple. The price-to-earnings multiple, or P/E, compares a company's earnings with its share price. The P/E is determined by dividing a company's share price by the company's earnings per share. So, if a company's stock price is $100, at its quarterly earnings are $5 a share, it has a P/E multiple of 20. (To determine P/E, some investors use "trailing" earnings, which means earnings from previous quarters, while others use estimated earnings, or estimates for earnings in coming quarters.)

But the right P/E isn't an absolute: In the old days, the standard of where a stock should sell was a P/E multiple of 10 to 15. In the bubble years, the average stock on the S&P 500 index traded with a P/E in the mid-20s. On the fliside, Wall Street is willing to embrace Netflix, the DVD-rental-by-mail company, with a 12-month trailing P/E of 83, because it is the leader in a high-octane growth sector.

For companies that don't have earnings, such as promising tech firms, some analysts focus on additional valuation methods, such as price-to-sales ratio.

Based on their analysis of choice, investors then decide whether a company's stock is undervalued or overvalued. Since nobody knows anything about how a stock will perform, even the best analysis is an educated guess. But that's part of the market's grand design: Enough educated guesses can result in a self-fulfilling prophecy, since investments in a company influence how that company performs.

Value Judgments

The subject of valuations provides an endless debate on Wall Street. The following articles offer guidance on the slippery subject of valuations:

The Perils of Low P/E Investing

Navigating Book-Value Traps

Q&A: Finding Value With Robert Olstein

Sound Bites Those Who Heed Them

Book These Values

Explaining the Dividend Discount Model

A Different Approach to Value

When Price Is the Catalyst

The Fed Model Impels, but Does Not Compel

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