How to Calculate the Value of Stock With the Price to Earnings Ratio

by Slav Fedorov

Price-to-earnings (P/E) ratio is a company’s stock price divided by current earnings per share (EPS). EPS is a company’s net earnings divided by the number of shares outstanding. When you multiply a stock’s EPS by its current P/E, you get the current stock price, or how much investors are currently willing to pay for a dollar of earnings. The lower the P/E, the cheaper the stock. Value investors often use a stock’s P/E to determine if a company is under- or overvalued -- or whether the stock is a good buy at the current price.

Step 1

Obtain a company’s long-term EPS growth rate from a financial portal such as Yahoo! Finance or MSN Money for the past three or five years.

Step 2

Calculate the current EPS growth rate by comparing the EPS for the last two or three quarters to the same quarters last year.

Step 3

Compare the EPS growth with the current P/E. The current P/E can be obtained from an extended quote provided by Yahoo! Finance or a similar portal. The rule of thumb is that a fully valued stock should have a P/E that equals its earnings growth rate. If the P/E is below the EPS growth rate, the stock is undervalued; if the P/E is above the EPS rate, the stock is overvalued.

Step 4

Assume that the stock you are researching is fully valued -- that is, its EPS growth rate equals its P/E. Substitute the EPS growth rate for the current P/E and multiply it by the current earnings per share (which can also be obtained from a financial portal) to arrive at the stock’s potential value. If the figure is higher than the current stock price, the stock is undervalued; if the figure is lower than the current stock price, the stock is overvalued.

Tips

  • Use historical P/Es instead of EPS growth rate in your calculations to see if a stock is over- or undervalued by historical standards. You can obtain historical P/Es from a stock data service provider such as Value Line or MarketSmith, a service of Investor’s Business Daily.

Warnings

  • Be careful: these calculations are theoretical and may or may not lead to profitable results. The market always has a reason for valuing a stock the way it does. On the other hand, extreme market conditions, such as a sharp correction, investor panic or excessive fear, can cause good stocks to be undervalued relative to their underlying businesses or historical averages.

References (1)

  • “One Up on Wall Street”; Peter Lynch; 2000