29 Nov 2021
For many investors, “investing” means buying stocks. But before setting foot into this relatively high-risk market, we need to ask ourselves: do we have any idea how stocks are valued? And how can we tell if a stock is worth its market value from its fundamentals?
We’ve all seen or heard of this standard disclaimer: “stock prices may go up or down”. But what causes price fluctuations?
Stock prices are closely tied to supply and demand. Supply is determined by the market availability of a certain stock, and demand by the market desire for that stock. Stock price rises when the demand is high and supply is low, and falls when supply is high and demand is low.
Two key factors affect stock value. The first is what we call “fundamentals”. They include a company’s profitability, financials, and market perception of the company’s outlook. The second involves macroeconomic factors and market conditions, including interest rate, central bank’s monetary policy, as well as market sentiment.
A growing company may lead to a heightened market demand for its stocks. However, if the general market sentiment is pessimistic, more investors may choose to sell their shares which results in a drop in demand for the company's stock. This leads to a fall in its stock price.
How can we tell if the a stock is overvalued or undervalued? Here are some indicators:
“Corporate earnings” only tells you how much profit a company is making, and not how much profit it is returning to its shareholders. Earnings-per-share (EPS) goes deeper: it indicates how much the shareholders gain for each share of the company they own. You can work out the EPS by dividing the corporate income by the number of outstanding shares.
We can also study how the stock price of a company compares to its earnings-per-share, referencing the price-earnings ratio (PE ratio), which is the stock price divided by EPS.
Generally speaking, a lower PE ratio means better value. For example, if company A's stock price is at $50 with an EPS at $10 and company B's stock price is at $10 with an EPS at $1, company B appears to be the better deal judging only from its price. But when you look at their PE ratios, company A is actually considered cheaper compared to company B due to its higher EPS.
Before you buy, you can dig into a company’s historical and forecast figures of PE ratio to determine its current value and its outlook. PE ratios vary from industry to industry: tech companies’ PE ratios tend to be higher, while companies of traditional industries such as manufacturing and raw materials usually have lower figures. This means the PE ratio is mainly used to compare stocks within the same sector or with similar businesses.
Price-to-book ratio is another good indicator of stock value, comparing the value of a company’s assets (book value) to its market value. To work out the PB ratio, take the stock price and divide it by the net asset value per share (NAVPS).
If a company’s price-to-book ratio is below 1, it means its market price is lower than its book value, indicating a relatively better value for your investment.
Conversely, a ratio above 1 means a company’s market price is higher than its book value. For example, if company C's stock price is at $20 with an NAVPS at $10, it means the market is buying the company’s assets at twice its net value.
Besides valuation, investors should take other factors into consideration, including a company’s profitability, financials, and news about mergers and acquisitions, and so on. Macroeconomic factors can also have an impact on stock price. Since there are multiple factors influencing stock performance, you may also invest in a group of stocks like funds or ETFs to diversify your portfolio and lower risks, while capturing wider opportunities.
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