In Part 1 of this series, we discussed a stock price relative to financial metrics—such as market value per share, book value per share, earnings per share, and dividends per share.
Today, let’s take it a step further and learn about the relationship between those metrics and a company’s stock price.
We’re going to use “price to earnings” as the main example because it’s the most well-known.
Price to Earnings Ratio (P/E Ratio): In our Part 1 post, the hypothetical company’s annual earnings are $3 per share, and its stock market price is $100 per share. The company’s P/E ratio is calculated by dividing its price per share of stock by its annual earnings. For this company, its ratio is 33.3x. ($100 per share [stock price] divided by $3 per share [annual earnings per share]).
Why does this ratio matter? Well, because it reflects how much the stock market values the company’s earnings. For example, if the P/E ratio were 16.7x instead of 33.3x, then the company would only trade for $50 per share, not $100 per share.
In general, the faster a company is growing, the more the stock market values its earnings. So, if you purchase a stock with a high P/E ratio, this means the market is expecting its earnings to grow fast!
The same calculations apply for other financial metrics (see Part 1). This same hypothetical company has a book value of $60 per share and trades for $100 per share, so this means the company is trading at 1.67 times its book value.
Now you know the basics of how to value to a stock!