Step 6: Estimate the stock's value
There are many different valuation techniques. A fairly general one which goes well with this tool is to consider the company's value based on quantitative measures (such as earnings) and then adjust based on qualitative measures (such as management quality). Here are some of the quantitative measures investors use to arrive at a valuation (each can be calculated with the data collected in Step 3):
Price/earnings (P/E): As mentioned above, the P/E ratio is the most common measure of how expensive a stock is. The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period. The value is the same whether the calculation is done for the whole company or on a per-share basis. The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings.
Price/sales (P/S): A stock's capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don't reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don't have a P/E ratio.
Price/earnings growth (PEG): This is equal to a stock's price/earnings ratio divided by its year-over-year earnings growth rate. In general, the lower the PEG, the better the value, because the investor would be paying less for each unit of earnings growth. Investors who prefer rapid-growth companies often feel the current P/E ratio isn't an accurate representation of the company's value because they expect the earnings to be substantially higher in the future, and so they use PEG to factor in that expected growth.
Keep in mind that not every strategy is based on comparing price to intrinsic value. There are other methods you might want to consider, like technical analysis or momentum investing, but each has its own set of techniques that are beyond the scope of this tool.
In addition to considering these valuation ratios, it's also worthwhile to factor risk into the evaluation. As an investor you should be rewarded for taking risk. For example, if you're hoping for a 5% annual return from a given stock, but safe money market accounts are currently yielding 5%, you'd be better off with the money market account.