People often ask me what is the true value of a stock, or why does a stock even have value. Unfortunately, there isn’t a simple answer to how one would value a stock, because it’s a complex riddle, based on balance sheets, market forces, consumer sentiment, and a whole host of other variables. Work with me here, as I will do my best to articulate what are the ‘balance sheet variables’ that determine a stocks value.
First we must understand what a share of stock represents.
Stock is simply ‘equity’ or the representation of ownership, in something of value. Something of value could be a business, like Coca-Cola, or a privately-owned family insurance company.
Heck, you could even have Stock in a vehicle, raw land, or an investment property. It’s a means of dividing the overall market value of something into smaller parts, which then could be given to other people so they too, can have ownership.
Here are the top 3 ways to value a stock:
#1 P/E Ratio
P/E (Price to Earnings) Ratio is a metric used by many in the finance space, and it’s one of the metrics used to determine whether a stock is overvalued or undervalued. It is generally considered that the lower the PE ratio, the better the value is at the time.
A company’s P/E Ratio changes throughout the trading day, simply because the price is always changing, so its a bit of a moving target. Not to mention, it is based on the company’s recent earnings report, or previous 12 months earnings often referred to as TTM (trailing twelve months).
How the Market, calculates a P/E Ratio.
Generally a company’s PE ratio is calculated by taking the current trading price and dividing it by, the most recent Diluted Earnings per share. Diluted Earnings are earnings where all expenses have been amortized out of it. So, lets look at Tesla (TSLA) and calculate its P/E Ratio.
Tesla’s, TTM (trailing twelve month) earnings at last report, was $7.37. The price is currently trading at $737.12 per share, which gives it a current P/E Ratio of 100.01. This PE would be considered high, especially when compared to a competitor such as Ford (F) which is trading at a P/E of 4.18.
But, P/E is not alway indicative of the true value of a stock, and this is a great representation of why. Ford has a really low PE, which may mean it is undervalued, but its debt load says something entirely different.
Ford’s long term debt for period ending March 31, 2022 was $87.315 Billion, Ouch! Tesla, $7.03 Billion.
So, as you can see P/E is just one metric to use to determine a stocks value. A companies debt load, is also another metric often used determine the value of stock, and its current trading price.
#2 A companies Debt to Income ratio.
As you may have guessed, if a company has too much debt, it’s not worth investing in. Looking at the Debt to Income Ratio of a company needs to be part of your strategy to evaluate whether a stock is a good buy or not.
This is where taking advice from the notorious ‘Value Investor’; Warren Buffett himself, will pay dividends when it comes to evaluating a stocks debt position:
One of my favorite Buffett quotes on Debt:
Buffett is not a fan of investing in companies with excessive debt. But, what’s considered excessive debt? To Buffett, the sweet-spot for company debt, is when the company has the ability to repay its long-term debt obligations, with no more than two years of its net earnings.
Seems a bit hawkish, but this is why he’s a billionaire, and I’m 900,500,000 short of Billionaire Status. I’d take his advice on how to value a stock based on its debt.
I’s also take his advice on buying value stocks that pay a nice dividend, then utilize a drip program to reinvest each dividend.
See my post on why investing in dividend stocks is a fantastic means of accumulating wealth, especially for a W2 employee.
Yes, this is a real word! Ok, well it’s considered real in the financial space and its very useful when valuing a stock. EBITDA stands for: Earnings, Before, Interest, Taxes, Depreciation, and Amortization.
Let’s discuss EBITDA one letter at a time so it resonates a bit clearer.
Earnings= the gross income the company took in during the most recent reporting period.
Interest= The amount of interest the company paid during the reporting period. This refers to interest on things like; Real Estate debt, Secured Debt, Tax Exempt Corporate Debt, and Convertible Debt to name a few.
Taxes= What the company’s tax liability was during it’s most recent reporting period.
Depreciation= From a tax perspective, depreciation can be beneficial, as it represents a decrease in the value of assets over time. So, because something is worth less tomorrow than today, your tax on that ‘something’ goes down over time. Types of corporate depreciation are: Straight Line, Double Declining Balance, Units of Production, and Sum of Years Digits.
Amortization= Debt Paydown. This reports how much was paid to a loans; principal and interest. Amortization measures the ‘value’ added due to the debt paydown during a specific reporting period.
If you’re planning on investing in a particular stock and holding it for a long time, it is best to use these to determine a good entry point. But, if you’re a short term holder, you may have a greater interest in these prediction metrics.
Here are 3 great ways to predict a stocks trading direction.
#1 Relationship to the stocks 200 day moving average.
The 200 Day Moving Average is an indicator of price movement over a 200 trading day time horizon. It’s a calculated average price using each days closing price over the last 200 days of trading.
Professional traders use this, as ONE of their calculations to predict the direction of the stocks price.
It is assumed that if the price is trading above the 200 day moving average, this may present a Buying Opportunity, with a Support level being just below the trading price.
If the stock is trading below the 200 moving day average, it’s seen as a Selling Opportunity with Resistance just above the trading price.
For a great in-depth post on the 200 day moving average, check out Tradingwithraynor.com as he is a wealth of information.
If you want to investigate 5 stocks trading significantly below their 200 day moving average, check out these stocks:
#2 Using Bollinger Bands to predict stock movement.
John Bollinger, came up with the idea, aptly called ‘Bollinger Bands‘ in the 1980’s when he was trading options. He used standard deviations to determine the high and low price range along a continuous moving average.
The image below shows the current chart of Chevron (CVX) with its Bollinger Band highlighted in orange. Chevron’s current price is on the low end of the Bollinger Band, representing a perceived low price, because of its 2 standard deviations below the moving average.
Bollinger Bands aren’t a perfect science and are simply considered ‘one tool in the toolbox’ that traders use, to predict price movement.
#3 Linear Regression
Using Linear Regression to predict the movement of stock prices, is merely one piece of the pie. Linear Regression uses a sample of price movement from previous trading days, to act as a model of anticipated future behavior.
A simple regression equation includes one dependent and one independent variable and is defined by this mathematical formula:
y = m*x + c
In this equation, y is the dependent variable, m is the regression coefficient, also referred to as the slope, and x is the independent variable and c is a constant. In simple terms, y is the output where m, x, and c are used as inputs.
Stock Traders use Linear Regression as one tool to predict price behavior, but…
Linear Regression does have its limitations. For instance, the time frame y is subjective and if it’s too short, the data output will most likely be unreliable. Also, Linear Regression has no way to predict some sort of a Black Swan event, such as the Crashes of 1929, and 1987.
Linear Regression, Bollinger Bands, and Moving Averages are simply tools to a stock trader, just like hammers, nails, and saws are tools to a carpenter. They serve to improve the traders accuracy and timing, so it’s important to not rely on them whole-heartedly.
Next up on how to value a stock, we’ll look at different stocks that look undervalued according to the principals laid out in this post.