Stock Valuation: Understanding Fair Value & P/E Ratio

There are two primary schools of thought in stock valuation--technical and fundamental.Technical analysis looks at historical price and volume trends for a stock. Fundamental analysis looks at finding discrepancies in the value of a company and its market value, that is, fundamental analysts believe that a stock is not necessarily valued correctly in the market. One way analysts try to identify the fair market value for a company is with a metric called the P/E (price to earnings) ratio.

Step 1

Calculate the P/E ratio. The formula used to calculate the P/E ratio is "current stock price per share" / " current earnings per share."

Step 2

Compare the P/E ratio for your company with other companies in the same industry. For instance, if you want to find the fair value for a bank, you must compare the P/E ratio to other P/E ratios in the banking industry.

Step 3

Interpret the meaning of the P/E ratio. A high P/E ratio means the company is overvalued and a low P/E ratio means the company is undervalued. For instance, if I own a company with a P/E ratio of 5 when the average P/E ratio for companies in the same industry is 3, I know that my stock is overvalued (expensive).

Step 4

Adjust the stock price down to the average P/E ratio for the industry. If the average P/E ratio is 3, and the P/E ratio on my stock is 5 (current price $10 / earnings per share $2), then I can use the P/E equation to find what the stock price would need to be in order to have a P/E ratio of 3. The equation is: New P/E ratio x Earnings per share. The answer is 3 x $2 or $6. The fair market value for this stock is $6, not $10.