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Ultimately, the value of a stock is determined by the forces of supply and demand. Investors are willing to purchase a stock at a price that provides for a reasonable return on investment and that fairly compensates them for the risk of stock ownership.

In theory, the market is a perfectly efficient valuation mechanism where the value of every stock is perfectly calculated and represented by its price. And in a world of perfect information that theory would approach reality. Unfortunately - or fortunately, depending on your perspective, we live in a world of imperfect information. Imperfect information in the stock market spells uncertainty. And uncertainty magnifies risk. Ultimately then, stock valuations are dependent on a host of different variables and subject to the collective whims of individual investors. In short, stock valuation is an imprecise science.

Price / Earnings Ratio

One of the measures that investors use to judge the value of a stock is the stock's price to earnings ratio - also known as the P/E ratio. The P/E ratio tells us how many years it will take us to recoup our initial investment if the future profits continue at current levels (all other things remaining equal). For example, if a company generates $1 of profit for each share of outstanding stock and the stock is currently selling for $18 per share then the P/E ratio would be calculated as the price per share ($18) divided by the earnings per share ($1). This would yield a P/E ratio of 18. A P/E ratio of 18 suggests that if company earnings were to remain constant into the future (at $1 per share), it would take 18 years to recoup your initial $18 investment. Eighteen years is quite a long time to recoup your initial investment. So why would anyone want to buy stocks?

Well, the reality is that earnings at most companies do not stay flat - they grow over time. This is an important concept. Because if company earnings are growing rapidly from year to year, it will not take 18 years to return the initial investment. This is what investors are counting on. This is why P/E ratios tend to be higher for companies that have demonstrated an ability to rapidly grow revenues and earnings. P/E ratios of 25 to 50 have not been uncommon for fast growing companies in the most recent bull market. In the heyday of internet euphoria, P/E ratios for the hottest dot.coms exceeded 200 - an absurd and ultimately unsustainable earning multiple. Historically, P/E ratios for common stocks have averaged around 15. That is to say, that on average, investors have been willing to pay up to 15 times current year earnings for a share of stock. It is important to understand that this is an average. As mentioned earlier, faster growing companies typically will merit a higher P/E than companies whose sales and profits are growing more slowly. Certain cyclical companies, such as auto manufacturers typically have lower P/E ratios than say, a typical high-tech company. A high or low P/E ratio is not a sufficient justification to buy or shy away from a stock. The company's P/E ratio has to be evaluated in the context of the industry, the economy, and the forecasted performance of the specific company. Having said that, be wary of companies with extremely high P/E ratios. When the market takes a turn for the worse, stocks with lofty P/E ratios will generally be among the hardest hit. Ultimately there are only two ways to reduce a high P/E ratio: by dramatically increasing company earnings, or by reducing the stock price. If you buy a stock at a peak P/E multiple, don't be surprised if you're left holding the bag as investors stage a wholesale retreat when it becomes apparent that the stock is fundamentally overvalued. Paying 200 times earnings for a stock is equivalent to lending someone 100 dollars and having them pay you back at the rate of 50 cents per year - not a very astute investment.

Future Earnings Potential

Remember, as a stockholder, your share of stock entitles you to a percentage of future company profits. Just because a company has done well in the past, does not guarantee that it will continue to operate profitably into the future. As you begin to evaluate prospective investments you would be well advised to carefully study future earnings forecasts published by the company as well as outside analysts. When purchasing the stock of a company, future direction and profitability is far more important than past performance and profitability.

Evaluating Stock Investments

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