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Earnings And Sales To Determine Stock Value

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Earnings And Sales To Determine Stock Value

Investors are always on the lookout for cheap investments, but how do they decide how cheap a company’s stock is?

Earnings and sales price have something to say about it.

Looking for cheap stock

There are two essential elements used by investors when trying to find the best-valued stock, price to earnings and price to sales ratios.

These two methods allow investors to calculate how cheap a company’s stock is.

Price to earnings ratio

The price to earnings ratio (or P/E ratio) takes the current price of a company’s stock and measures it against the earnings the company has made per share.

The calculation for this would look as follows :

  • Stock price = $43
  • Earnings per share = $1.95
  • The P/E ratio = 22.05
  • Stock price / earnings = P/E ratio

The figure used in earnings per share is usually calculated using the last four quarters.

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Comparing price to earnings ratios

Once you have calculated the price to earnings ratio, you can use this figure in other calculations.

A standard calculation undertaken by investors is to compare the P/E of stock by the P/E of the index.

The calculation of the P/E ratio means comparing the price per earning of a company with the price per earnings of the average stock on the stock exchange.

Forward price to earnings

The forward price to earnings is the predicted/ estimated price to earnings ratio of stock in the future.

The downside to working out the forward P/E is the unreliable nature of predicting future stock.

However, it’s a helpful indicator to aid calculating future risk.

Price to sales

The price to sales ratio (or PSR) is the company’s stock price compared to the company’s revenue.

There are two possible calculations:

Calculation one:

  • Market capitalisation = $20 million
  • Total sales = $10 million
  • PSR = 2
  • Market capitalisation/ total sales = PSR

Calculation two:

  • Stock price = $105
  • Sales per share =$35
  • PSR = $3
  • Stock price / sales per share = PSR

As with price to earnings ratio, you can also compare the PSR of stock against the PSR of an index and calculate the forward PSR.

Advantages and disadvantages of P/E ratio

The price to earnings ratio is incredibly easy to work out and common amongst investors who want to work out the value of an investment.

The price to earnings ratio is the measure that’s generated for shareholders and can also predict future earnings.

The disadvantages of the price to earnings ratio is the inability to take into account the financial situation, cash generation, or investment returns of the company.

The comparisons undertaken by investors can also be undermined by the different accounting methods and policies across different companies and countries.

Price to earnings cannot be used to check the value of companies that are in the early stages of growth, are loss making, or are cyclical businesses.

Advantages and disadvantages of PSR

The sales revenue will always be active, so if a company is in distress, the price to sales ratio will still be meaningful.

The sales income is not as easy to manipulate as other figures and the PSR is not as unpredictable as the P/E ratio, this leads to clearer and more exact numbers.

The PSR is also a more reliable way to calculate the value of a start-up, mature, or cyclical companies, where other methods may lead to misleading results.

Disadvantages of the price to sales ratio include the risk of sales made using credit will naturally inflate the PRS.

Individual revenue recognition practices may also lead to distorted sales figures. There are also different cost structures across companies and these won’t be represented by PSR.

P/E ratio vs. PSR

There are both positives and negatives to working out the price to earnings/ sales ratio of a company, but which method better represents the company’s value?

When you are seeking to check the value of a start-up company which has not managed to achieve profitability the prices to sales ratio will give you a more accurate indicator of the market’s expectation of the stock.

However, to predict the future promise of a certain company’s earnings and then the price to earnings ratio is better suited for determining what the markets expectation is.

In the early 1990s most investors used the PRS to check the price of a potential investment.

The rise of the internet changed how investors approached their investments as they became willing to taking risks and base their investments on the potential growth of stocks and not their current stock price.

The PRS works better in gauging a company’s stock valuation but the future growth a company is better calculated by the P/E ratio.

Since the base of future predictions is on estimates and they are not very reliable, PRS is more stable than forward P/E ratios which are based on current figures not estimated figures.

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