Whether you're new to the stock market or an experienced investor, it's important that you know how to determine a stock's value. Once you understand the key concepts – and the finance industry's jargon – you'll be better able to decide whether a stock is overpriced or a good deal.
Price-to-earnings (P/E) ratio: This figure compares the price of a stock to the company's earnings per share (EPS). A lower ratio generally represents a cheaper valuation, meaning the stock price is low but the company has high earnings. P/E ratios vary among different industries, so it's a good idea to evaluate a stock's P/E ratio in comparison with other similar stocks.
Historical P/E ratio: By using previously reported earnings, such as those from the year before, this ratio can provide a helpful reference for evaluating the stock's current P/E ratio.
Forward P/E ratio: This number is based on forecasted EPS over the next year. It can offer clues about a company's future prospects.
Price-to-book ratio: This ratio compares a company's stock price to its book value per share. The book value is based on a company's balance sheet – its assets and debts. High ratios may indicate overvalued stocks, while low ratios may indicate undervalued stocks.
Dividend yield: This is the percentage of a company's share price that it pays out to investors annually.
Growth industries frequently have higher P/E ratios, suggesting higher expectations for future growth. Some of the tech giants from the past couple of decades are good examples of this category.
Traditional industries normally consists of industrial and materials stocks. Many investors believe these types of stocks have less room for growth, and they often trade at lower P/E ratios as a result.
When evaluating a stock's value, you could consider the company's financial condition and operational capabilities. Also, look out for any recent news about mergers and acquisitions that might affect how the market prices the stock.
These include things such as government policies, interest rate directions, economic conditions and market sentiments, any of which could also affect stock prices.
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