The Definitive Guide: How to Value a Stock

So something that still surprises me to this day is how many people believe that a stock is either cheap or expensive based on the price per share thinking that a $100 stock, for example, is expensive. Well, a $10 stock they might consider to actually be cheap. And sure, on the face of it, there is a technical difference in the initial price that you pay for a stock. 

But that doesn't determine whether it is cheap or undervalued, or expensive or overvalued, it matters more. So what you get in return for the price that you pay? For example, if you pay $10,000 for a Ferrari, that would still be considered cheap. While paying maybe $1,000. For a Big Mac from McDonald's would be considered extremely expensive, 

And stocks are no different $100 stock could still be very undervalued. While a $10 stock could still be considered extremely expensive and overvalued. It's really only when we factor in different things like a company's sales or their profits, maybe a dividend, they pay their assets or liabilities, things like that, that help us make the determination of whether sock is truly cheap or expensive for the price that we pay in relation to other stocks in the market. 

So in today's article, I'm going to show you exactly how to calculate and determine that for yourselves using what I think are the quickest, most simplified methods that I actually use myself to quickly and effectively value stocks. Okay, and first up here, let's start with the website, Yahoo Finance. So we can get a quick overview of some valuation metrics. 

And I'll explain each one of these as we go through the list. So let's go ahead and type in the search bar, MRK, which is the ticker symbol for one of my favorite value dividend stocks that I actually own myself, which is a company called Merck. And this is a giant pharmaceutical biotech company.

Market Capital

And if we click on the Statistics tab, we can see some of the most commonly used basic valuation metrics and ratios. And first, up here we have the market cap at $221 billion, which is just the total dollar value of the company in the stock market. And it's calculated by multiplying all of the company's outstanding shares by the price of each of those shares. 

And the reason why we use the market cap is because the individual share price alone doesn't tell you how big the company is, and their total value for that you need the market cap. Now I generally categorize market caps into small caps at less than $2 billion medium caps at between 2 billion and $10 billion dollars and large caps at over $10 billion. 

And then I also categorize mega-cap companies at anything that is over $200 billion. And a lot of investors use those general guidelines as well. So in Merck's case, we would consider this giant company, a mega market cap company, because they do surpass that $200 billion mark. 

Now generally, small-cap stocks tend to be riskier, because they're usually a younger companies with a smaller size and a smaller track record of success. Larger cap stocks, on the other hand, tend to be much larger corporations that have more stability, and a larger history that you can look at and research to make a more educated decision on. So they tend to be a little bit safer. 

But the only drawback is that those larger cap companies, they also tend to have smaller growth rates, because they're already so massively large that you know, there's just not that much more room for them to keep growing, while smaller cap companies, they tend to have a lot more room for expansion and a lot of market share, to steal and things like that. 

So essentially, you know, small-cap stocks, those tend to be higher risk, but sometimes they can also be higher reward potential in some cases. Obviously, there can be exceptions to all of this, but that's just kind of a general rule of thumb.

And it's one of the reasons why my larger positions in my own portfolio are usually mega-cap stocks because of their reliability and stability, which gives me a good foundation to build the rest of my portfolio around them. 

Enterprise Value

In the next valuation measure, we also have is the enterprise value. The enterprise value at over $240 billion for Merck, which is very similar to the market cap, except that here you would also add on the company's debt minus their cash. It's more commonly used for takeover purposes.

Because it really tells you what the actual prices are that you'd have to pay. If you wanted to acquire the entire company since you'd also have to take on their debt. 

PE Ratio

The next valuation measure, more often used by regular investors like us for valuing a stock is the PE ratio, otherwise known as the price-to-earnings ratio. And this metric is calculated by taking the price per share and dividing that by the company's earnings per share, otherwise known as the EPS which is basically just the profits of the company, you know, the profits per share. 

So, you're dividing the price by the profit to see how well a company is performing in relation to the price that you're paying for the stock. And so the lower that this P E ratio number is compared to its competitors. Well, the cheaper or perhaps more undervalued the stock is considered to be.

But also just keep in mind that a higher PE ratio can sometimes be the result of investors willing to pay more money for the company now because it is expected to have higher growth in the future. So the general rule of thumb is that high PE ratios are usually attached to more expensive growth stocks, while low PE ratios are usually attached to cheaper value stocks. 

Of course, there can be huge exceptions to this because sometimes a high PE is just based on irrational hype or maybe because the profits are really bad, while a low PE ratio can also be caused by something that is fundamentally wrong with the company or maybe their future outlook.

So investors are just not willing to pay a high price because they know that the company is in decline or you know, things like that. So either way, just make sure that you do plenty of research on the company itself rather than just blindly jumping into a stock based on a couple of metrics like this. 

In any case, the PE ratio can also be broken down further into what we call the trailing PE and the forward PE. And all that means is that the trailing PE uses the company's profits from the past year, while the forward PE uses profit expectations for the following year. 

And a general rule of thumb here is that the trailing PE is useful for judging the price based on actual performance that has already happened. While the forward PE can give you a better idea of where the company is expected to be in the near future. Both are extremely valuable for their own purposes, though, so I would consider both. 

PEG Ratio

The next valuation measure is called the PEG ratio or the price to earnings to growth ratio, which usually uses the following five years of expected profits to make the same calculation. But in order to be able to look out a bit further into the future. I personally love investing for the long term. 

So I really like using the PEG ratio a lot. And generally, a PEG ratio that is lower than one is considered to be cheap, just because it means that their expected growth is actually higher than the PE ratio. While anything above one might be getting a little a little expensive since you're paying a higher price for that future growth. 

I know all of this might, you know, be sounding a little confusing, but the best way to keep all of this simple is to just simply compare these metrics of the company that you're looking at, versus the rest of the market and their biggest competitors. So to give you an example, in Mercs case, their trailing PE, forward PE, and PEG ratios of around 13,11, and 1, respectively.

These are all considered pretty good and cheap when compared to others. For example, if we go to multiple.com, we can see that the PE ratio for the s&p 500 index, which is usually referred to for valuing the broader stock market, it currently sits much higher at over 20. 

And more importantly, if we go to seeking alpha.com and we click on the valuation tab for Merck, we can see that their PE and PEG ratios are around 40 to 50% cheaper than the rest of the healthcare sector. And not just that, but we can also see that mercs valuation is even 20 to 60% cheaper than their own five-year average.

So in other words, merch stock is looking like a pretty good value here at these levels when you compare them to, you know, their competitors when you compare it to the sector, and even when you compare it to its own self and its historical averages. mercs valuation is pretty low when you do those comparisons. 

And I'll show you a couple more reasons why I also think that Merck stock is cheaper too. But just to finish up here with the Yahoo Finance metrics really quick, I'll just quickly explain the rest of these that are not as commonly used as the others, but you know, they can sometimes come in handy too, so I'll just quickly run through them.

PS Ratio

Then in the valuation measure, we've got the PS ratio or the price-to-sales ratio, which is useful for valuing a stock that is not currently profitable, since you divide the price by sales instead of profits, and for this one, a PS ratio of less than 1 is generally considered a good value since you're technically paying a smaller price than their actual sales.

But just know that most investors care much more about profits since that's what really matters. In the end, you can have all the sales in the world if you want. But if you're not making a profit, you're eventually going to go bankrupt. So it may be okay to use a PS ratio for a younger, you know, more speculative stock at first. But just know that eventually, you want to start to see them make some profits.

PB Ratio

And then in the valuation measure, we're going to want to use the PB ratios (price to book ratio) to really value them more effectively, then you also have the PB ratio, or book value per share, which uses the company's net assets to see what kind of material wealth they already have, and what you're getting in return for the price.

And just like the PS ratio, you generally want that to be closer to one if possible. So in Merc's case, you know, it's a little high. But I don't really use that metric much myself anyway, because I really care more about the overall health of their balance sheet which I feel is kind of related to this. So I look at that more so than the PB ratio. 

Three more things

Okay, so we now have a great foundational understanding of how to quickly value stocks using some basic valuation metrics. But there are just three more things that I want to quickly mention to you guys that I think are super important to consider when also valuing a stock. 

The Business and Performance

And number one, that would be the business and performance of a company number two, the balance sheet. And then number three, the dividend if the company happens to pay one, Okay, and starting with the first one here, the business and performance, obviously, you'd have to do a ton of research.

You'd have to know their products, their competitors, the market, they operate, and all that kind of stuff to really, you know, understand a company's business and performance. But just to give you a quick recap of Merck specifically and why I invest in them. To give you an example here, well, Merck not only generates huge sales and profits already by the tons of billions of dollars.

But they also have a huge pipeline of over 100 different future products that they'll be releasing over the long term to ensure that they continue to have more growth in the future. And that's already resulting in sales growth expected by 20%. This year, and then they also have an average EPS or earnings per share growth of you know, basically profit growth of over 10%, on average over the next five years.

Which is even higher than the previous five years. So overall, you know, they're seeing really good growth, they're already seen very stable financials, they've got a lot of products. And by the way, that earnings growth is also one of the reasons why their PEG ratio is so low at around 1.

So all of that looks really good for Merck. And by the way, if you ever want to look up any of this information for your own stocks, just click on the Financials tab or the Analysis tab on Yahoo Finance, it gives you all that information as well. 

Balance Sheet

The second point, though, that's going to be the balance sheet. And there are many reasons why a balance sheet is very important when investing in a stock, you want to make sure that they have ample cash and ample assets so that they can get through difficult times so that they can reinvest back into the company, many reasons why the balance sheet is crucial for any investment. 

So for this one, you can just click on the balance sheets tab in Yahoo Finance. If we look at the balance sheet here for Merck. And I would say that it's pretty good overall. I mean, they've got billions in cash, they have more current assets and current liabilities, which is anything that is basically due within a year, they can afford to pay all of that. 

And we calculate that, by the way, by looking at the current ratio, and they have it at 1.4. Anything above one is generally considered good. But they're at 1.4. And then they also have more assets than total liabilities. And we calculate that using the total ratio, and we have that 1.6. Mercs balance sheet is good. 

It's good enough to invest in it's not anything special. If you look at Microsoft, Apple, you know, maybe meta Google, those companies have amazing, you know, spectacular balance sheets. There'll be much better than this one, but still overall Mercs balance sheet, it's solid. It's good enough to invest in, in my opinion.

The Dividend

The third point is the dividend. And so if you go to seeking alpha.com And you click on the dividend tab for Merck. You can see that their dividend yield is very attractive at over a 3% yield meaning that they pay you over 3% of your investment every single year just for owning the stock. Then they also Have a payout ratio that is low at only 35%, meaning they only use 35% of their profits to pay dividends out. 

So they still have plenty of money left over for reinvesting back into the business. And also, you know, strengthening their balance sheet many other things. And then the five-year growth rate for the dividend is close to a double-digit percentage, which is also you know, reasonable, it's a little low, but it's not too bad. 

And then the growth history at 11 years of consecutively growing that dividend every year, that's also pretty good, you know, over a decade of growth there. And if we click on the dividend yield sub-tab, we can also see that their dividend is also more than 100% higher than the sector average. So it's a fantastic dividend overall, in my opinion.

So when I put the whole picture together, at least for me, Merck really ends up looking like a pretty good value here at these levels. And these are the general methods that I would use to make a quick determination here on Merck. These are just tiny pieces of the overall giant puzzle. 

There are so many things that we'd have to research and talk about if we really want to determine whether a stock is a buy or not. But overall, I think that this is a good place to start. I hope that you were able to get some value out of this article this will help you to research any types of stocks or buy a stock.