Not An Easy Question

How much a stock is worth is different depending on how you look at a stock.  There are many criteria that can be evaluated to determine a stock's worth, and not every one of them is the correct answer.  However, by knowing what some of these values mean, you can better create your own indication on the value of a company, and by extension their stock value.  It just takes some research, and knowing what you are looking for.

First, Why do You Want to Buy the Stock?

There are a couple of ways people make money in stocks.  One common way of making money is buying a stock and then, hopefully, selling it at a higher price.  In this case, you want to look for a stock that is under valued by the rest of the buyers and sellers out there.  However, sometimes there are other reasons why this stock is 'under valued', so simply looking for the cheapest stocks is not necessarily the answer.

Are you buying stocks for the income they will produce for you?  Many stocks, though not all, pay dividends to their shareholders.  These dividends represent potential income, and if a stock stays relatively stable, you could generate income much like a bank certificate of deposit does.


Second, How Long Will You Hold on to a Stock?

How long do you want to own the stock?  Is your time frame 10 years, 10 months, or 10 minutes?  Or do you take the Warren Buffett approach and hold a stock 'forever?'  This is important, because that could change what you are looking for in a stock as well.

If you are looking for a quick stock price jump, then you might be looking for some news to make changes to the stock.  Mergers can do this, as can surprises in earnings reports.  Outside factors can also affect a stocks price as well.  

If you are evaluating a company for a longer term, you will be looking for the value to go up over time.  This is done with steady improvements in the company, either on the revenue side or the expense side.  When a company can keep doing the same amount of revenue, but cut costs while doing it, they will make more money.  Likewise, if a company can increase sales without increasing costs, they make more money that way.

So, What do We Need to Know?

The value of a company is based on many factors, so lets look at some of them.  First, what net worth of the company?  Net worth is the total value of all of the assets, minus the total amount of debt the company owes.  Just like your household net worth, except the numbers are often bigger.  

So, if the company I am evaluating has $1 million in assets and $500,000 in liabilities (debt), then the net worth of the company is $500,000.  So, if there are 100,000 shares of the company outstanding, then the net worth of each share of stock might be $5.  There is no guarantee you will get $5 per share if the company closes (assets may not sell for listed values, and creditors may add penalties for late payments or interest or other factors not listed on the current sheet).  However, it does provide a baseline to at least look at.

What Else can We Look at?

Some of the value of the stock is not what it owns today, but what it will be worth tomorrow.  Assets are not always revenue generating, they simply represent what the company owns.  So, some other numbers to look at include the Price to Sales (P/S) or Price to Earnings (P/E).

P/E is often used to evaluate the stock's worth.  To determine the P/E, you need to find 2 numbers for the company (actually, the P/E is often found in the data itself, but it is good to know where it came from).  So, if the P of a stock is $10, and the E of a stock is $2/year, then the company has a P/E ratio of 5 (10 / 2 = 5).  Now, is a P/E ratio of 5 good?  Historically, ABSOLUTELY, but you need to know where similar companies are to determine whether a 5 is good or not.

Let's take a second company whose stock has a P of $21.  Let us say that company has an E of $3/year.  Now, looking at these two companies side by side, which one is a better buy?  On the surface, stock 2 might look better.  After all, it is earning $3/year (per share) whereas stock 1 is only earning $2/year.  

However, this is where the P/E ratio allows us to compare two dissimilar values.  The P/E of stock 1 was calculated as 5.  The P/E of stock 2 is calculated as 7 (21 / 3 = 7).  So, this means, for every $5 of stock purchased of company 1, I will earn $1/year.  However, it requires me to purchase $7 in stock 2 to receive the same $1/year.  Therefore, company 1 is a less expensive buy because it has a lower price for the earnings.

That is not the last word on the subject, however.  If tomorrow both stock 1 and stock 2 announce their earnings, this could change the facts of the case.  Let's say stock 1 had a bad year and only earned $1 this year.  If stock 2 simply performed the same, now the ratios change.  Company 1 has moved to a P/E of 10 (10 / 1 = 10), while company 2 has stayed the same at 7 (21 / 3 = 7).  Now, in a single day, company 2 is the less expensive stock (on a price per earnings basis).

Forward Price / Earnings

Price / Earnings is based on the current stock price (this can change throughout the day as prices go up or down) and the most recent earnings information.  It does not predict future earnings, only past earnings.  So companies will issue forward looking statements, announcing what they anticipate the company will do in the future.  These statements are estimates based on current knowledge.  However, I am certain that quite a few companies in New Orleans expected to make a lot more money before Hurricane Katrina stuck the city.

Given all things to be equal, it is entirely possible that a company's estimates of its future performance will be accurate.  It is also entirely probable that something unexpected will happen and the models will be completely wrong in the end.  Be careful looking at events a company hopes will happen, when even the most unpredictable things can change those plans in an instant.

However, the Final Conclusion is Also Unreliable

In the end, a stock's value is based on what the next person to own your shares is willing to pay for it.  They may do the same research you do.  They may do more research, they may do less.  However, they are going to look at the stock you own and come up with their own calculation to determine what the company is worth.  That is the price they are willing to pay, and it might not agree with your own value of the company.

All things being equal, if you do the homework on a company and its stock, you should come out alright.  However, one unexpected event could bring the price crashing down and you end up with a worthless piece of paper that says you (used to) own shares in a company.