Q: Are there rules of thumb that warn investors they're overpaying for a stock?
A: When you press the "buy" button on your broker's website, a flashing red light doesn't go off and warn you that you're overpaying for a stock.
The reason: There's really no way of knowing for sure if the current stock price is a steal or not. Analysts use all sorts of techniques to estimate what they think shares are worth. But since stock prices are determined by bidding between buyers and sellers, it's not unusual for stock prices to drift away from what a logical estimate says it should be.
But don't get discouraged. While it's difficult to pinpoint what a stock will trade at any point, there are some fundamental analysis tools you can use to help provide guidance. Understanding some basic valuation techniques can help you at least avoid being the investor who pays up for stocks and suffers as a result.
A few rules of thumb to consider:
•Price-to-earnings ratio. The P-E is one of the most followed and commonly maligned ways to see how much investors are paying for stocks. Simply stated, the P-E ratio tells you how much investors are paying for a claim to a company's earnings. For instance, the broad stock market defined by the Standard & Poor's 500 currently has a P-E of 13.9, based on earnings the past 12 months. That means investors are paying $13.90 for a claim to every dollar of corporate earnings. You'll want to know what the P-E's on stocks you own are, and how they compare with the rest of the stock market.
•PEG ratio. Critics of the P-E ratio, and there are many, point out that some companies are worth paying more for. Typically, these investors say that companies with higher levels of growth should, and do, get higher P-E ratios. One mathematical way to adjust for this is the PEG ratio, short for P-E Growth. With the PEG, you divide the P-E ratio by the company's expected growth rate. Going back to the S&P 500 example, say you expect earnings to grow 8% a year. Divide the P-E ratio of 13.8 by 8 to arrive at a PEG ratio of 1.7. Typically, investors think stocks are getting pricey if they have a PEG ratio of 2 or more and appropriately valued with a PEG of 1.
•Price to book ratio. This ratio is one of the favorites of academics. Academic research has shown correlation between stocks' price-to-book ratios and their risk and returns. Investors who like to buy stocks with low price-to-book ratios are typically value investors, while those targeting stocks with high price-to-book ratios are thought to be growth investors.
To arrive at a price-to-book ratio, investors divide a stock's price by its book value. The book value of a company is its assets minus its liabilities, which are all data available in the financial statements. The S&P 500 currently has a price-to-book ratio of 1.91, says Morningstar. If you own stock in an individual company, you'll want to calculate the price-to-book ratio and see how it compares with the market.
•Comparative analysis. Some industries command higher valuations than others, and investors must compensate for this in their analysis. For instance, the technology sector has a higher-than-average P-E of 18, says Thomson Reuters. But on the other hand, stocks in the energy sector tend to have a lower P-E ratio of 11.1. Rules of thumb are often highly dependent on what sector or industry a stock is in.
There's no easy rule that will tell you if a stock is overvalued. If investing were that easy, there'd be no need for a stock market. But using the basic techniques of fundamental analysis described above, you can at least get a handle on how richly a stock is valued.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at firstname.lastname@example.org. Follow Matt on Twitter at: twitter.com/mattkrantz