A $10 stock can be more expensive than a $500 one. The share price on your quote tells you almost nothing about whether a stock is cheap. This week you find the number that does.
Learning objectives. After this week you can (1) compute earnings per share and the P/E ratio; (2) compute a dividend yield; and (3) tell a stock's intrinsic value from its market price.
Remember this: compare what you pay per dollar of earnings, not the sticker price.
1) Earnings per share (EPS)
EPS = Net Income ÷ Shares Outstanding
Net income is the company's profit after every cost. A firm earning $10 million with 5 million shares has EPS of 10 ÷ 5 = $2: each share you own stands for $2 of profit.
2) The price-to-earnings (P/E) ratio
P/E = Price per Share ÷ EPS
A stock at $100 with EPS of $5 has a P/E of 100 ÷ 5 = 20: investors pay $20 for every $1 of this year's earnings. A high P/E usually means investors expect strong growth; a low P/E can mean a bargain or a company in trouble.
3) Dividend yield
Dividend Yield = Annual Dividend ÷ Price × 100
A $2 annual dividend on a $50 stock yields 2 ÷ 50 × 100 = 4%: the income you get each year for every dollar of price.
| Price | EPS | P/E | Dividend | Yield |
|---|---|---|---|---|
| $100 | $5 | 20 | $2 | 2% |
| $60 | $3 | 20 | $3 | 5% |
4) Intrinsic value vs. market price
Intrinsic value is your estimate of what a stock is really worth, based on its earnings, growth and risk. Market price is what it trades at right now. Price well below your estimate suggests the stock may be undervalued; price far above it, possibly overvalued. Investing is the search for that gap.
Quick self-check
(a) A stock trades at $40 with EPS of $2. P/E? (b) A $1 annual dividend on a $25 stock. Yield? (c) Which is cheaper per dollar of earnings: a $10 stock with EPS $0.20, or a $100 stock with EPS $10? (Answers: 20; 4%; the $100 stock, P/E 10 against 50.)
Common mistakes
- Judging by share price. A low price is not a low P/E.
- Dividing the dividend by EPS. Yield divides by the share price.
- Treating intrinsic value as a fact. It is your estimate, and it can be wrong.
This week in the arena
Pick one stock you hold. Take its price from your Extrapoli quote, look up its EPS and annual dividend on Yahoo Finance or Google Finance, and compute its P/E and dividend yield yourself. Then look up the P/E of one company in the same business and see whether yours looks cheap or expensive next to it.