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how to evaluate a security?

Typically when we refer to value in the stock market we’re talking about the value of the underlying company.  This is different to terms like ‘overbought’ or ‘oversold’ which we often hear in technical analysis focusing purely on price movement.  

Today we’ll be focussing on the fundamental value of a company.  

PE Ratio

There are many ways to value a company.  The simplest of these is the price to earnings ratio often referred to as the PE ratio.  This ratio is calculated by dividing the price by the earnings per share (EPS), e.g. if the closing price of a share is $4.00 and earnings per share for the past year was 25 cents, then the PE ratio will be 16.  

Price / EPS = PE Ratio

On average the market PE ratio is 15, so a share with a PE ratio less than 15 is considered undervalued and a PE ratio higher than 15 is considered overvalued.  

Unfortunately determining undervalued or overvalued is not quite this simple because the PE ratio is based on historical earnings, (i.e. last year’s) and doesn’t take into account what may happen in the year ahead.  Perhaps the overvalued share has just been awarded a new contract, which will mean a big earnings jump, or maybe the undervalued stock has just lost one, which will have the opposite effect.  It’s very important to look at the growth in the company as well as the current PE ratio.  

PEG Ratio (Price Earnings to Growth Ratio)

In some situations the PE ratio may be very high and the share could still be undervalued.  The reason for this is that the company is growing its profits very strongly and the share may become good value in the near future.  The PEG ratio helps us determine how growth will impact on underlying value.

This is calculated by dividing the PE ratio by the EPS growth, e.g. if the PE ratio is 20 and the EPS growth is 30% then the PEG ratio will be 0.67.   

PE ratio / EPS growth = PEG ratio

If the PEG ratio is low, less than 1, then the company is considered to...