Many novices might consider a stock’s price on the stock market to be a single number. The DJIA ticker at the bottom of the newsfeed lists a single price, after all, and an arrow to indicate whether it’s rising or falling. The reality is, stocks are evaluated based on four different metrics, all of them collated into a more objective value.
#1: Price-to-Book ratio
This represents the value of a company’s stock were it to be dissolved today. It’s the rock-bottom value you can use, derived from the company’s hard assets such as real estate, patents, and equipment. It’s the “worst case scenario” among valuations.
Example: A software company would fare poorly in the price-to-book ratio since it has minimal hard assets consisting of a few computers and some intellectual property.
#2: Price-to-Earnings ratio
This is the valuation of a stock based on its expected return on investment. Put simply, it answers the question “How long would this stock take to pay for itself if I bought it today?” It’s based on the assumption that nothing in the company’s current performance changes. It is a “guesstimate” however, based on forecasting and predictions.
Example: A hot new start-up company still in its early years will typically have an optimistic price-to-earnings ratio since it’s expected to perform well in the future.
#3: Price-Earnings-to-Growth ratio
Commonly abbreviated as “PEG,” this is a valuation method which takes into account the past performance of the stock, as well as its expected future performance. It’s a somewhat more solid figure than price-to-earnings alone.
Example: The longer a company has been around, the more likely it has a higher price/earnings-to-growth ratio. Established brand names that have been around for decades and have no immediate jeopardy to their market fall here.
#4: Dividend Yield
This is a performance metric which looks at the dividends alone. It assumes you will never sell the stock in the future, but merely sit back and collect the dividends indefinitely.
Example: Companies which tend not to be otherwise attractive on the other metrics try to attract investors with higher percentage yields. Tobacco companies are a case in point; tobacco use is at an all-time low in popularity, but still has a steady enough profit margin that tobacco companies can afford high dividend payouts.
Each of the methods of evaluating stock tends to tell only part of the story. We need a combination of the above methods to form a composite evaluation of a stock’s value. There are actually several more methods of stock evaluation, but the four methods listed are the most commonly cited.