As of this writing, the S&P 500 has risen 18% year to date and is within 3% of its all-time high. Against this backdrop, it's understandable why many investors are worried there's a lot of overvalued stocks out there. However, not all investors know how to objectively determine what's overvalued and what's not.
In this video from Motley Fool Live, recorded on Sept. 9, contributors Matthew Frankel and Jon Quast offer some ideas to investors about how to value stocks. Specifically, Matt explains key concepts like the price-to-earnings ratio, the price-to-sales ratio, the price-to-earnings growth ratio, and the price-to-book ratio. And while these four metrics are important for investors, this video explains something even more important: how to use them effectively.
Matt Frankel: With that, I'm going to share my screen and we're going to talk a little bit about valuation. Bear with me because I'm not very good at this part either. I'm probably the least tech savvy guy on this platform, you'll find.
We'll start off with the traditional valuation metrics. What you need to know about them and why they're not good in every situation. Obviously, something like the price-to-earnings ratio doesn't make sense for the company, doesn't have earnings. But a lot of these metrics have little subtle differences that makes sense in certain cases.
With that, here are some of the traditional valuation metrics that you should just keep in your back pocket. I use these a lot because like I said, I'm primarily a value investor, at least 80% of the stocks in my portfolio can be evaluated by the metrics you're seeing on the slide. They are worth knowing. Like I said, the goal of a high-growth, unprofitable stock is to eventually get to where these apply. Even if you are the most growth-minded investor, at some point you're going to need these.
The price-to-earnings ratio. Jon, you remember back when like everybody just used this as their valuation metric?
Jon Quast: Yes. I was one of them.
Frankel: It's the most basic and easiest to learn and applies to pretty much every mature business. Easy to calculate, it says right there, you simply divide the stock price by the annual earnings per share. As Jon mentioned in his S&P slide, you can either do this on a trailing-12-month basis or on a forward basis, using projected earnings. That's what that forward EPS is, that's why that's different.
Not applicable to non-profitable companies, and companies that are just in the early stages of making a profit. This can be very high. I'm going to talk about a stock later whose price-to-earnings ratio is about 400. Not a great metric for it.
Price-to-sales can be a much better metric for growth stocks. Pretty easy to calculate also, you divide the company's market cap by its trailing-12-month revenue. You can use forward sales also if you want the forward price-to-sales. That can usually put the growth rate into perspective if you compare the two.
Going on just a couple more. The price-to-earnings growth ratio. This is one of my favorite metrics to use when I use a combination of value and growth investing. Essentially, this is taking the traditional P/E ratio and adjusting it for growth. You divide a P/E ratio by the expected growth rate of the company. For example, a company that has a P/E ratio of 30 that grows earnings at 15% per year would have a price-to-earnings growth ratio of PEG of two. This is really useful for comparing companies in the same industry that are growing at different rates.
Finally, and then I'll let Jon take over, the price-to-book ratio, I especially like this metric for evaluating bank stocks because earnings don't always tell the full story. Banks release reserves, they do things that don't really have anything to do with how much money they're making. The price-to-book ratio can be a great way to evaluate companies where earnings don't tell the whole story. This is essentially the company's share price divided by its asset value per share after factoring in debt. So, the shareholders equity per share. It could be a good way to level the playing field.
One key takeaway before I let Jon go is, not one of these is a great metric all by itself. Like any type of stock analysis, all of these should be used in combination with the other ones on the list.