Every investor dreams of uncovering the dog that (quickly) becomes a darling.
After all, market headlines trumpet soaring share prices that can sound astronomical: Amazon.com (symbol: AMZN) hit a high nearing $200 in October, more than four times where it traded five years earlier; Apple (AAPL) has cleared $500, up 480 percent in five years. But always remember that an eye-popping per-share price (or a low one, for that matter) without proper context tells investors very little about where a stock might be headed.
"Investors, understandably, are often confused about what the dollar price of a stock means—in regards to what it says about the company, where it's at relative to other stocks, and what it might say about where shares are headed," says John Fox, director of research at Fennimore Asset Management and co-manager of the FAM Value Fund.
"Berkshire Hathaway A shares at $118,000 are at one of the lowest valuations in several years. Is that cheap or expensive?" he quips. That's right, a $100 stock may be cheaper than a $3 stock. It's the difference between price and value.
One key measure is price-to-earnings (PE) ratio: price per share divided by earnings per share; the lower the number, the better the potential "value." For example, a PE ratio of 20 suggests that investors are willing to pay $20 for every $1 of earnings the company generates.
Investors can make a further distinction between trailing or forward PE. Trailing PE measures the price of a stock against the past 12 months of earnings. The value then lies in past performance, with the assumption that those trends are likely to continue.
Forward PEs divide the current price of a stock by the estimated earnings in the coming 12 months. The forward PE bases the value of a stock on expectations for growth no matter what happened in the past. Trailing might be preferred if an investor feels a company (or the analyst firms that follow it) routinely overstate earnings projections. "For our discounting mechanism, we look at forward PE," says Fox.
If a company has a PE higher than the market or industry average, this means the market is expecting big things. The company will have to deliver, justifying that number, or the stock price will need to drop. Comparing companies in the same industry is straightforward; comparing PE multiples for unrelated stocks across industries is not.
Investors can also look at share price-to-book value, measuring a company's net worth. Essentially, a company's assets minus its liabilities.
But PE and book value alone are often not enough. For instance, consider financial shares. They look attractive on price alone because many trade below their book value these days, notes Fox. But the outlook for the sector may make financials a value trap.
"You often can't look at one dimension like PE. You have to look at profit margins, return on capital investment, among other factors, on top of valuation," says Fox. "You can certainly buy a bad business at a low price."
Also, Fox says investors shouldn't necessarily jump because dividends sweeten the "value" picture. A stock with a dividend yield range of 2 percent to 5 percent can improve a stock's overall profile. But dividends alone "do not create value," says Fox. A company's ability to pay dividends—or make acquisitions or buy back shares—simply reveals a positive cash story and yes, that's a factor to consider.