Is Your Stock Expensive or Cheap? Here’s One Way to Tell.

March 22, 2023 | by V. Henry Astarjian | Posted in Blog

When we investment advisors say that a stock is expensive or cheap, what exactly do we mean? Are we talking about price only or is there more to it than that? This question often confuses investors, especially newer ones, so it’s worth clarifying.

What we usually do not mean is that the price of a stock is too high or too low. “High” and “low” are subjective frames of reference and often have little to do with how good an investment a stock may be. Is a stock that’s trading at $150 a share less attractive than a stock selling at $50 per share? The higher priced stock may in fact be a better bet than the lower priced one. The more important question is, which stock is a better value?

Value is a concept that all of us as consumers can understand immediately. It’s how many oranges we can buy for $10, or how many square feet of real estate we can purchase for each $1,000 that we spend.

When we buy a stock what we are really buying is the future stream of earnings, or dividends, or sales, or cash flows that the underlying company generates.

To show how this works, let’s take one of the most commonly used measures of value in the stock market, the price-to-earnings ratio, or the P/E.

The P/E answers the simple question, how much do I have to spend per share of a particular company in order to get $1 of that company’s earnings? The metric assumes that you are the company’s only shareholder – the P/E you get is for the whole company.

As with oranges or with real estate, a lower ratio may indicate a better deal for you as a buyer.

In the case of the $150 stock, if the underlying company earned, for example, $10 a share in profits the company’s P/E ratio would be $150/$10, or 15 times. That means you would have to spend $15 to get $1 of that company’s earnings.

If, on the other hand, the $50 stock represents a company that earns $2 per share in profits, the $50 stock would have a P/E ratio of $50/$2, or 25 times, meaning that you would have to spend $25 to get one dollar of that company’s earnings.

This is what we mean by expensive or cheap when we talk about a stock. The concept can apply to the entire stock market as well where we take the price of the whole market and divide it by the market’s earnings in order to get the market’s P/E. The price and the earnings per share of the S&P 500 Index are commonly used for this purpose.

Beyond P/E there are other valuation methods that are worth exploring. Knowing whether your stock is expensive or cheap is an important consideration when making a selection for your portfolio.

Disclosures: Waterstone Advisors, LLC is a Massachusetts registered investment advisor. Registration with securities authorities does not imply a certain level of skill or training. Investing carries risk of loss, including loss of principal. The information and data presented in this note have been compiled from publicly available sources that are believed to be reliable. However, their accuracy is not guaranteed. Waterstone Advisors LLC does not guarantee the performance of the securities or strategies discussed or analyzed in this note. An investment in these securities or strategies may result in complete loss of principal. For additional information and disclosures, please see our ADV Part 2 (the “Firm Brochure”) in the Our Approach page of our website at www.waterstoneadvisorsllc.com, or contact us at 978-828-2188.