By compiling companies data we are able to generate ratios to value stocks. Ratios such as the price to earnings, earnings per share, enterprise value to sales, and enterprise value to ebitda (earnings before interest tax depreciation and amortization), are all great way’s to see how a company stacks up against one another in the same industry. There are a few things that you need to know before you start comparing company’s ratios against one another.
- Make sure they are in the same industry. – It would not make sense to value Ford versus Apple right? Think about it. One is the largest tech company in America, and the other is a leader in the manufacturing of cars and trucks. When looking to compare company’s make sure they operate in the same industry. I would look to compare Ford to GM for example.
- Lower does not necessarily mean better.- A great way to find an undervalued security is to find a low price to earnings and a lower earnings per share (.50-3.00 EPS is what I tend to look for). However, if a companies ratios are too low it may be a sign to back off. For example if company A has a PE and EPS of 15/3, this may be better than company B whose PE and EPS is 2/.03. Company A is more profitable and may represent the stronger company.
- Market Cap is Key.- When looking to compare company’s make sure the market capitalization is relatively similar. You do not want to compare Amazon (market cap of over $917B) to JC Penny (market cap of $419M). By keeping the market caps relatively close you will have companies who are in similar stages of their lives.
- Growth vs. Value- When looking to compare company’s make sure you know if a company is a growth or value stock. A growth stock will have a much higher PE and may not have made a profit yet so they will not have an EPS. On the opposite side of that a value stock may have a lower PE because their shares have gradually risen and they have produced a profit.
Using ratios to compare companies is a great way to figure out which investment to make. Remember, recognize growth vs. value stocks, match companies by industry and market cap, and know that a very low ratio may be a sign of a company struggling to produce rather than them being undervalued. Have a great day!