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Saturday, September 18, 2010

Evaluating Stocks - Cheap or Expensive?

As an investor in stocks, what do analysts mean when they say 'stocks are cheap or expensive'? You often hear this in connection with a story on whether it is a good or bad time to buy or sell.

Often, they are referring to the PE (price earnings ratio) of stocks. This metric tells you how much investors are willing to pay for the earnings a company produces. In general, the higher the PE, the more 'expensive' a stock.

A stock's PE is computed by taking the current price per share and dividing it by the earnings per share (EPS).

Formula: Price per Share / Earnings per Share = Price Earnings Ratio.

For example, a company with Rs. 5 EPS and a current share price of Rs. 50 would have a PE of 10. This tells you that investors are willing to pay 10 times the EPS for the stock.

As you can see, if earnings remain constant, but the price per share continues to rise the PE will be higher. At some point, the stock will be deemed 'expensive,' which often precedes a recommendation to sell. Conversely, as the PE falls, the stock will become 'cheap' and may be a buy candidate.

Of course, PE is just one tool in evaluating stocks, below are some more.

2. Price to Sales – P/S

3. Price to Book – P/B

4. Dividend Payout Ratio

5. Dividend Yield

6. Book Value

7. Return on Equity - ROE

However, none of these tells you at what PE is the stock cheap or expensive. For individual stocks, you need to look at industry peers to compare their PEs. If companies in the stock's sector are showing higher PEs, then your candidate may indeed be cheap. Likewise, if the sector has lower PEs, the stock may be expensive.

You can also look at the whole market to see if, in general stocks are cheap or expensive. A good way to do that is to examine the PE for the Sensex, which is considered representative of the whole stock market.