The Valuation of Stocks

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    Price-to-Earnings Ratio

    • The most familiar way to value a stock is to look at its price-to-earnings (P/E) ratio. The P/E ratio is calculated by taking a stock's earnings per share and dividing it by the price per share. For example, if a stock has a P/E ratio of 15, it means the price of the stock is valued at 15 times its annual earnings. Arguably, the lower the P/E ratio, the more valuable the stock.

    Sales

    • The price-to-sales ratio (PSR) is another way to value a stock. This ratio is calculated by taking the total price of all outstanding stock shares and dividing it by the company's revenue over the past year. Revenue is not to be confused with earnings as it represents proceeds from all sales, regardless of whether sales earned a profit. Like the P/E ratio, the lower the PSR number, the better.

    EBITDA

    • Earnings before interest, taxes, depreciation and amortization (EBITDA) is an item in a company's earnings report that represents the company's cash flow. EBITDA is the total amount of cash that flows through a company over a quarter after fixed expenses, such as bond and loan payments, are deducted. This can be a useful method of valuation for companies that have large expenses to get started, such as a biotechnology firm that has heavy research costs. For example, a company may not have any earnings the first few years due to upfront costs, but EBITDA lets you know if its cash flow is improving from one quarter to the next.

    Equity

    • If a company stops earning money and all cash flow stops altogether, it still owns assets, such as buildings, equipment and even brand-name recognition. The difference between the value of these assets and the value of the company's liabilities is the company's equity. Equity valuation methods are sometimes used by companies that may be considering purchasing another company. For example, it is possible for a company to be worth more divided up, offering good buyout potential. This could happen if a company has good brand-name recognition, but poor earnings. Another company may be able to buy the company cheaply for the purpose of using the company's brand-name recognition and selling off its other assets.

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