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Several common measures are available for calculating the value of
common stock. While most shareholders look mainly for the price
per share, it’s not the only indicator of a stock’s worth. Other factors
include: earnings per share, the price-earnings ratio, net asset value
per share, and yield.
Return on Equity
Return on equity (ROE) is a very important stock measure because it
has a direct impact on the company’s growth, profits, and dividends.
It shows the overall profitability of the corporation, and seizes how
much success the company is having in managing its assets, operations,
and capital. The better the ROE, the better the financial condition
and position of the firm. Stable or increasing ROEs are good
indications. However, stocks with falling ROEs should be avoided.
Earnings Per Share
This is the most commonly referred-to indicator of a stock’s value.
Whenever you turn on CNBC or look at the stock pages of the Wall
Street Journal, there are mentions of earnings per share (EPS). The
traditional way to compute this is to find the income of a corporation
that is available to its shareholders. This is net corporate profit after
taxes and minus any dividends to preferred shareholders. This figure
is then divided by the number of outstanding common shares of
stock.
For example, XYZ Corporation reports that its net corporate
profits (after taxes) are $5.8 million. They must pay $1 million out in
preferred dividends. The remaining $4.8 million is divided by the
number of XYZ’s outstanding common shares, which is 1.2 million.
Thus, their EPS is $4 per share.
$5.8 m - $1 m = $4.8 m = $3.20/share
1.2 m s + .3 m s = 1.5 m shares
This method of calculating EPS is called the “basic earnings per
share.” It is also known as “trailing earnings per share” because it is
based upon the corporation’s reported earnings, which are in the past.
Quarterly and semiannual EPS also use this method. However, analysts
will also forecast a company’s future earnings and base their
EPS on these.
Companies also have what are called “diluted earnings per
share.” These are computed by dividing the available income to common
shareholders by the number of outstanding shares of common
stock plus any shares that would be outstanding if any employee
stock options or stock awards outstanding, convertible securities and
warrants were considered (dilutive potential common shares). In
some cases, the difference between the basic EPS and the dilutive
EPS is great, solely because of the number of dilutive potential common
shares. Note the difference in the earnings per share in our
example when dilutive potential common shares are considered. EPS
drops from $4/share to $3.20/share.
$5.8 m - $1 m = $4.8 m = $3.20/share
1.2 m s + .3 m s = 1.5 m shares
Analysts usually place a lot of emphasis on earnings per share.
It’s important to note that when they discuss EPS, they generally are
referring to the diluted earnings per share. They also cite the EPS
when discussing the trend for certain companies. However, we can
say that the share price will keep up with the earnings per share,
either rising or falling. In the past few years, we’ve seen more of a
disregard for EPS when it came to new issues and hot dot.com
stocks, which was due, in part, to the fact that these companies had
no earnings. But with the market downturn, we’ve returned to using
the EPS as an indicator of how a company is doing.
Price-Earnings Ratio
The price-earnings ratio (P/E ratio) for a common stock is found by
dividing the share price of the stock by the current earnings per
share. Therefore, from our previous example, XYZ’s EPS was $4 per
share. If their stock price was $55 per share, their P/E ratio would be
13.75 ($55/$4).
The P/E ratio is also a highly respected method of measuring a
stock’s value. Generally, the lower the P/E ratio, the better the stock
buy. However, a high P/E ratio is all right if the company’s earnings
are expected to grow. When evaluating a stock, it’s a good idea to
look at the historical P/E ratio data. Looking at the trends for a par-
ticular stock will help you decide if the present is a good time to buy
or not. If you find that the present P/E ratio is pretty low when compared
to the historical figures, the stock may be a good purchase.
Net Asset Value per Share
Net asset value per share, or book value per share, is the amount of
assets a company has working for each share of common stock. It’s
calculated by taking the net balance sheet values of corporate assets
and subtracting the face value of any creditors’ and preferred shareholders’
claims. This number is then divided by the number of outstanding
shares. So, for XYZ Corporation, the company’s assets
totaled $59 million and their debts and preferred stock claims were
$21 million. The remaining $38 million is divided by the number of
outstanding shares, 1.2 million. Thus, their book value per share is
$31.67.
$59 m - $21 m = 38m/1.2 m shares = $31.67
Generally, the book value for a stock is not a widely used indicator
of the stock’s value. It also isn’t as important as the company’s
ability to generate an earnings stream. For growth stocks, the market
value could be many times the book value. Conversely, for companies
that are in either static or declining industries, book value may
be much greater than market value.
Yields
For common stocks, yields can be measured as “nominal yields” or
“current yields.” These measure the rates of return for a stock. When
considering whether to buy, keep, or sell a stock, it’s important to calculate
the yields, so you can make an informed decision.
Nominal yields are calculated by taking the annual interest or
dividends paid and dividing it by the stock’s par value. This is often
called the “dividend rate” when applied to preferred stock. Nominal
yields really have no meaning for common stocks.
Current yields, though, are a more meaningful measurement for
investors. This is found by dividing the annual investment income by
the security’s current price. Current yields can be applied to common
$38 m
and preferred stocks, as well as bonds. Remember, these yields
change all the time due to the fluctuation in stock prices.
XYZ Corporation declares and pays a $2-per-share dividend.
Currently, their stock is selling for $60 per share. Their current yield
is 3.3 percent.
$2/$60 = 3.3%
Sometimes current yields and historical data on current yields
can be misleading. There are companies who increase their dividends
on a regular basis, thus increasing the current yield each time. Then
there are companies who, while very stable and financially sound,
have made a practice of paying little or no dividends. To calculate
properly the overall rate of return on a stock, go back and look at the
average annual compound rate of gain (or loss) over a period of time,
assuming all dividends and capital gains were reinvested. This considers
all capital gains and losses on the stock, instead of just dividends. | 
Disclaimer
