Any investor, when putting their money into stocks, hopes for it to rise in value. After all, that’s why we even start investing in the first place — to grow our money.
So you would have been overjoyed if you had invested in Tesla (NASDAQ:TSLA) since, in 2020, Tesla’s share price grew a phenomenal 695%. In comparison, the S&P 500 — the index that tracks the top 500 companies in the US market — gained 16% in the same year.
A 16% annual return is nothing to scoff at, especially if you’ve been passively investing in the index. But if you’re building your own portfolio and gunning for growth, Tesla seems like an attractive addition.
But given its insane price growth, you may also wonder: is Tesla really a high-value company that’ll continue outperforming the index or is it overinflated? Simply put, how do you know if Tesla’s stock price is justified?
It all boils down to how you value a stock, and it’s not just for Tesla stock. For any stock you purchase, you should do a stock valuation to determine if its current market price is too expensive or a good bargain.
What is stock valuation?
In investing, valuing a stock or an asset is a fundamental skill to add to any investor’s toolbox.
Stock valuation is the process of figuring out what a stock or an asset is actually worth right now, or in the future. This is commonly known as the “intrinsic value” of a stock.
Hence, if the current price of a stock is higher than the intrinsic value (as deemed by the investor), the stock is overvalued — it costs more than you think it should.
Ideally, you’d want to purchase undervalued stocks, stocks that are currently priced lower than their intrinsic value.
For example, if you believe that a stock’s intrinsic value is $100 but it’s currently trading at $50, you’ll consider that stock undervalued and you would buy it with the belief that the stock’s price would eventually increase to $100 and reflect its “true” value.
But how do you determine a stock’s intrinsic value?
How to value a stock
Unfortunately, there’s no one-size-fits-all way to value a stock, and two investors can look at the same stock and come away with very different intrinsic no values.
However, there are common factors that investors consider when valuing stocks. They are:
- A company’s current earnings (or potential future earnings)
- The company’s market share in its industry
- How the company stacks up against its competitors
- How much debt the company has compared to its revenue, cash flow, or assets
- The company’s expansion plans, product offerings, and management
Simply put, valuing a stock is much more than reading the news headlines and asking your financial advisor whether a stock is worth buying. You have to do the legwork and learn more about the company that you’re buying into.
One commonly used multiple to value stocks is the Price-to-Earnings (P/E) ratio. The P/E ratio essentially stacks up a company’s earnings (current or future) against its market price.
P/E ratio = Stock Price / Earnings per share (EPS)
Say a stock is trading at $100 and its current earnings per share is $20, the stock’s P/E ratio is five times (5x).
This number on its own doesn’t tell you much, but you can compare the stock’s current P/E ratio to its P/E ratio from a year ago, or to other companies in the same industry.
For example, if Stock A has a P/E ratio of 5x, but Stock B has a P/E ratio of 4x, an investor could conclude that Stock B is “cheaper” than Stock A. Caveat: A low P/E ratio alone isn’t enough to indicate if you should buy a stock. In Tesla’s case, its P/E ratio is over 1000x! So, if just based on the P/E ratio alone, Tesla would be too “expensive” to buy. Yet investors still buy Tesla’s stock, which pushes its price up further.
That’s because some investors don’t just look at what Tesla’s stock is worth today; they also factor in the company’s growth and earnings prospects. Famously, Cathie Wood’s Ark Invest – a fund manager – expects Tesla’s share price to grow to $3,000 by 2025.
Just as there are investors that believe Tesla’s stock is still undervalued, there are also investors who believe that the stock could be overvalued. One way to gauge how investors are valuing stocks is to read analyst reports from banks, fund managers, and financial research houses.
Don’t know how to value stocks? It’s not the end of the world
Though valuation analysis is an important part of the prep-work before deciding whether to buy a stock, it’s a skill that few people have the time to develop.
If you don’t have the time to do the research about stocks, you can opt to passively invest in the market. Passive investing allows you to still grow your money, albeit at a rate that doesn’t beat the market. And that’s okay, because your money is growing!
You can also invest in actively managed investment funds if you’d like to get exposure to specific stocks.
Active fund managers, such as Ark Invest, try to earn returns that beat the market by stock picking. Most fund managers have a team of analysts that will research and analyse the assets that they include in the fund. However, not all actively managed funds are available to regular investors.
If you’re interested to learn more about stock valuation, here are some recommended books to start your journey:
- The Intelligent Investor by Benjamin Graham and Jason Zweig
- The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit by Aswath Damodaran
- Security Analysis by Benjamin Graham and David L. Dodd
At the end of the day, there isn’t one magic metric to know whether a stock is worth buying and it’s up to you to decide. But before you start valuing stocks and adding them to your portfolio, always remember that investing involves taking calculated risks. So, make sure that you have enough emergency funds, before taking your first plunge to grow your money.