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Monday, August 16, 2010

Fundamental Analysis: Stock Price - Cheap or Expensive?

To find a cheap stock you need to know its fair value. If the current price is lower than its fair value, then you got your self a cheap stock. Cheap stock does not mean it has low rupee value. A Rs. 100 stock is called cheap if its fair value is Rs. 200, greater than it's current price. A Rs. 1 stock is called expensive if its fair value is Rs. 0.5, lower than it's current price.

A simple way to find out if a stock is cheap or not is by looking at it's P/E (Price / Earning) ratio. The P/E ratio is a measure of the price paid for a share relative to the profit per share.

PE = Price Per Share / Earning Per Share

A higher P/E ratio means that investors are paying more for each unit of income. The price per share (numerator) is the market price of one stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. Investors can use the P/E ratio to compare the value of stocks. If one stock has a higher P/E that of another stock in the same industry, all things being equal, it is a less attractive investment. Normally, stocks with high earning growth are traded at higher P/E values, because investor anticipate the high growth.

A more advance ratio fom PE is the PEG ratio. The Price/Earnings To Growth, is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that approaches two or goes higher than 2 is believed to be too high. This means that the price paid is to be much higher relative to the projected earnings growth.

The PEG ratio of 1 represents a fair value between the price and the company's growth. Similar to PE ratios, a lower PEG means that the stock is undervalued. If a company is growing at 30% a year, then the stock's P/E could be 30 to have a PEG of 1. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values.

Defining the projected growth rate is difficult. It will be wise enough to use reasonable future growth rate by checking quarter's earnings have grown, as a percentage, over the same quarter one year ago.

PEG ratio is suitable for high growing company and is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dividend income, but little growth. This dividend will affect price and PEG ratio.

PEG is a widely used indicator of a stock's potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.

Keep in mind that the numbers used are projected growth and therefore can be less accurate.