What Does It Mean That a Stock Is Over or Under Valued?

Hey, do you want to buy my car for $8,000?

You couldn’t possibly answer that question without knowing more about my car. What is the make? Model? Year? Miles? Does it run? You get it.

The same is true for investing. You need to know something about the stock before you can decide if it’s a good value or not.

Stick with me on this lesson. It’s a little longer than most and there is a bit of math involved, but the payoff is worth it. You’ll be able to answer this question by the end: “What stock is cheaper? One trading for $50 a share or one trading for $200 a share?” Of course, the answer will surprise you.

Here is how professional investors determine if a stock is a good deal or not: it’s called valuation.

They want to know, “If I buy a share of stock in this company, what am I really getting in return?” It all comes down to how much money the company is making, called the profit. How much money do they make after all of their expenses?

Remember we talked about how owning a share of stock in a company is really owning a part of the company? I guess it would also be important to know how many total shares the company has.

For example, let’s say you owned a single share of stock in each of these companies:

Big, Inc.

Total Shares: 100 shares
Your Shares: 1 share
Your Ownership: You own 1% of the company

Small, Inc.

Total Shares: 10 shares
Your Shares: 1 share
Your Ownership: You own 10% of the company

Okay, so that tells us something. It tells us how much of the company we own. But it doesn’t tell us everything yet. Think about it. Would you rather own 10% of my part-time babysitting business, or would you rather own 1% of Google, Home Depot, or American Express?

Why would you want just 1% of Google, when you could have 10% of my babysitting business? Because Google is huge and makes billions of dollars, and my babysitting company sucks.

That’s exactly right. Google makes billions of dollars (almost $20 billion a year!), and my babysitting business makes hundreds of dollars a year.

Okay, we’re getting somewhere now. It’s not just how much of the company you own, but it’s also how much money the company makes that’s important.

If only there was a way to figure how much earnings the company makes for each share of stock they have. Something where you could figure out the earnings for each share. Something like earnings per share. Fortunately, there is an easy way to figure that out, and it has this awesome name that’s really cool and exciting. It’s called earnings per share.

Now let’s have another look at our companies.

Big, Inc.

Total Shares: 100 shares Total Earnings: $100

Total Earnings per Share: 100 shares/$100 = $1 of earnings for each share (EPS)

Small, Inc.

Total Shares: 10 shares Total Earnings: $100

Total Earnings per Share: 10 shares/$100 = $10 of earnings for each share (EPS)

Hey, hey, hey! What do we have here? Our so called Small, Inc. company isn’t so small now, is it? For every share you own of it, you get $10 of earnings. I like it!

Okay, just one last step here. Think how far we’ve come. We learned it’s important to know how many shares there are of a company, as well as how much money the company makes.

Now we just need to see if it is a good value or not.

If I said, “I have this great 2015 Porsche 911 with only 300 miles and it’s in perfect condition, do you want to buy it?” what’s your first question going to be? What color is it? No! You’re going to ask, “How much are you asking?”

And that’s the final step. How much is one share of stock in the company? Once you know that, you can see if the stock is a good value with a quick and easy calculation called the P/E Ratio. It sounds complex, but it’s just taking the price of the stock and dividing it by the earnings per share.

Here’s how it works.

Big, Inc.

Total Earnings per Share: 100 shares/$100 = $1 of earnings for each share (EPS)

Price of the stock: $50 a share
Price/Earnings Ratio: $50 share/$1 EPS = 50 P/E

Small, Inc.

Total Earnings per Share: 10 shares/$100 = $10 of earnings for each share (EPS)

Price of the stock: $200 a share
Price/Earnings Ratio: $200 share/$10 EPS = 20 P/E

So Big, Inc. has a PE Ratio of 50, which means even though the stock price is just $50 a share, because there are so many more shares, each share gets just a small slice of the profit of the company.

On the other hand, Small, Inc. has fewer shares, and it only has to spread its profits to a small number of shareholders. So even though the stock per share is $200, you are getting a lot more profits per share.

The higher the PE Ratio means the less profit you are getting for each share of stock you are buying. So, the higher the PE, the higher the valuation, and the lower the PE, the lower the valuation.

As an investor, you will hear talk about valuations of a stock or the stock market as a whole is undervalued or overvalued. They are talking about the PE Ratio and how the current PE Ratio compares to their competitors and how it compares to itself over time.

For example, if the PE Ratio of UPS is 20 and the PE Ratio of FedEx is 100, that should cause some pause. They are both in the same industry. Why is FedEx so overvalued at 100 compared to UPS at 20? Or maybe, looking at it differently, why is UPS so undervalued compared to FedEx?

Whew! This lesson was a bit math heavy. Sorry! The takeaway? You can’t tell if a company is over or undervalued based on the price of the stock alone. A $50 stock might be much more “expensive” and overvalued compared to a $200 stock. You have to look at earnings and the amount of earnings for each share.

The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.