[Free Article] How do you know if a stock is expensive? by Henry Ong

QUESTION: I have been planning to invest in the stock market but share prices have been rising quite fast that I find it expensive to buy now. I don’t want to rush into buying a stock then regret it later because I could not sell it at a profit. Is there a way for me to pick the right stock? Please advise—Hazel Cruz by e-mail

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Answer: When everyone is chasing the market at increasingly higher prices every day, it is really difficult to buy stocks because you tend to make your investment decisions based on emotion rather than logic.

When emotions are involved, you tend to either buy on impulse because you want to earn quick money or not buy at all because you fear that it may be too late to get into the action.

Either way, unless you are born lucky, buying stocks based on gut feel alone always leads to losses.

But do not be discouraged if you cannot pick a good stock at this level when everything in the market seems to be expensive.

Actually, this is a good opportunity for you to take advantage of the strong market sentiment by buying stocks that have not yet reached their true value.

There are several approaches to valuing a stock.

The most commonly used is the Price-to-Earnings (P/E) ratio.

This ratio represents the earnings multiple that the market is willing to pay for a stock. You can compute this by dividing the current price of the stock by its earnings per share.

For example, to get the P/E ratio of PLDT, simply divide its share price of P2532 by its earnings per share of P175 to get 14.5x.

But getting the ratio itself doesn’t tell the whole story. You need to compare this to a similar stock, or the market average to know if there is still room for further upside.

If you compare the stock of PLDT to another telecom stock, you will see that it is less expensive than Globe, which has P/E of 16x.  If you compare PLDT to the market as whole, you will also find that the stock is cheaper than the market P/E of 18x.

Does this mean that when a stock’s P/E is at par with market average, it is not a good buy anymore? It depends.

As a guide, it only indicates that further appreciation of stock price based on P/E valuation may be already limited and you may be already paying too much so you better watch out.

In general, stocks that are considered expensive by P/E comparison may eventually fall because investors will begin to take profits by selling them down.

But there are exceptions. There are some stocks that command a certain premium because the market is simply willing to pay more for them.

For example, Ayala Land has P/E of 36x, twice the market average of 18x. Jollibee also has P/E of 30x. SM Prime Holdings has P/E of 28x.

There are many reasons why some stocks are worth paying more for. It can be market dominance, track record of management or strong earnings prospect of the company in the future.

One way to justify paying for high P/E is through the use of P/E to Growth ratio or simply known as PEG ratio.

This ratio assumes that some companies deserve to have high P/E because of their high earnings growth rate.

You can compute the PEG ratio by simply dividing the P/E ratio with the company’s expected growth rate.

Normally, PEG ratio of 2.0 and above is considered expensive. The lower the PEG ratio, the better.

To demonstrate, using the same example above, Ayala Land may have high P/E of 36x but its expected earnings growth rate is 24.8 percent, so if you divide its P/E by its growth rate, you will get PEG ratio of 1.45x.

If a PEG ratio of 2.0 is considered the limit, then these two blue chips absolutely have more room for upside.

Now that you know how to value a stock using earnings data of the company, be aware that making an investment decision should not be based on P/E valuation alone.

It is important to look at the qualitative factors such as the quality of earnings, and management credibility.

This is because the earnings that you see in the financial statements which you rely on to compute for P/E and growth rates may have been manipulated through the use of creative accounting.

You may not have the skills to detect potential fraud in the financials, but at least you can comfort yourself by dealing with people with integrity from the management.

Source: Inquire Business 12/04/2012