When you buy a stock, it’s often a good idea to understand exactly what you’re paying for. More specifically, you want to know whether you’ve found a bargain or are paying too much.
We can determine this using fundamental tools, such as the price-to-earnings (P/E) ratio, the price-to-earnings growth (PEG) ratio, and the price-to-sales (P/S) ratio. All will help you gauge the health of a stock you may be considering.
The P/E Ratio: Helping Assess Valuation
The P/E ratio is the difference between the share price and the company’s earnings per share. It’s used to examine if a stock is overvalued or undervalued.
For example, let’s say stock ABC is trading at $50 a share, and the company generates $2 per share in annual earnings. With those numbers, the P/E ratio would be 25, or $50 divided by $2. Given the company’s current earnings, it would take about 25 years of accumulated earnings to equal the cost of your $50 investment in ABC.
PEG: How Earnings Grow
The PEG ratio compares a stock’s P/E ratio to its growth. For some investors, a PEG ratio of more than 1.0 can be an indication a stock is overvalued; less than 1.0 can indicate the stock in question is undervalued. As noted by Investopedia: “The PEG ratio enhances the P/E ratio by adding in expected earnings growth into the calculation.”
P/S: The Essential Indicator
The P/S ratio allows us to see the value of a stock as compared to total sales over a 12-month period. It also tells us how much investors are willing to pay for every dollar of sales. A low price-to-sales ratio of, let’s say, 0.5 could be an indication of an oversold stock. A higher price to sales ratio can be an indication of an overvalued stock.
When it comes to investing, it’s essential that you know exactly what you’re buying. There’s no better way to do that than with fundamental analysis. In fact, some of the top investors in the world have strictly relied on this same type of fundamental analysis, including Warren Buffett, Benjamin Graham, Sir John Templeton, and Peter Lynch.
We can always get into other key fundamental tools at a later time. For now, these are three of the most essential ones to consider.