Valuing a stock is one of the most demanding tasks in the investment business. Experienced analysts have a love-hate relationship with the task, they pull their hair out over it while also relishing the possibility of unearthing an investment gem. Many individuals who are not investment professionals get around the problem of valuing assets by hiring an advisor or broker or buying diversified mutual funds or exchange traded funds (ETFs) themselves. Why should individuals care about stock valuation?

Smart investors should gain some understanding for stock valuation because it can help you understand what your advisor or broker is doing so that you can comfortably challenge and discuss why trades are executed or recommended.  This is not unlike people who decide to learn about their disease from online websites to improve the quality of their discussions with their doctors about their disease management.

Additionally, perhaps you hold inherited stocks outside of a professionally managed portfolio and feel totally out of your depth about deciding what to do with the shares.  Here are some basic things to think about:

First of all you need to decide if the company is a strong company financially; a good start is checking that it has a healthy balance sheet with ample cash and not too much debt. A good next step is to take a peek at the company’s income statement and see what the sales trends are. Are they consistent? Are they increasing or decreasing? What about profit margins? Are they rising or falling? You can find financial statements for all publicly traded companies on their website in the Investor Relations section.

Once you decide that the company is healthy, that it competes well in its industry, has a good management team, and can continue to grow its revenues then you can decide if you agree or disagree with the price the market has assigned it.

There are two general ways to value a stock: (1) a discounted earnings or cash flow model or (2) ratio comparisons.  The true theoretical value of a company is the present value of all of its future cash flows.  I will discuss ratios but not discount models in this article. Each ratio can be compared in three ways: the company’s current ratio compared to its previous years, the company’s ratio compared with peer companies in its industry, and the company’s ratio compared with the broader market, such as the S&P500. Here are a few ratios you can look at on Yahoo, Google, AOL finance pages.

1. Price to Earnings multiple (P/E)

The PE is the current share price divided by one dollar per share of earnings.  Simplistically that means that if you invest in a stock with a PE of 10 times and no earnings growth, it will take 10 years to get paid back what you invested. The lower the PE the better! You could look at the trailing PE which is the current price divided by the most recent four quarters of earnings or the forward PE which is the current price divided by an estimate of the future four quarters of earnings.

Historically the market has traded with price multiples as low as 7 times and as high as 45 times, and its historical average is a multiple of 14-16 times earnings. You can think of a PE of more than 20 times as being high but then again some companies deserve it.

1. PE to growth multiple (PEG)

The PEG is the PE divided by the expected earnings growth over the next five years for the company. The lower the PEG the better! Suppose a company is trading at a PE of 15 times and is expected to grow its earnings 5% per year over the next five years, that’s a PEG of 3 times. Stocks with  PEGs under 1.5 times are better values.

1. Price to Sales multiple (P/S)

The P/S is the current stock price divided by either the most recent four quarters of sales per share or the current price divided by the expected future four quarters of sales. The lower the P/S the better! The P/S ratio is a good way to compare companies that don’t have any earnings yet or their earnings are cyclical.

1. Enterprise value to cash operating earnings (EV/Ebitda)

The EV/Ebitda is the total value of the company equity and debt divided by its earnings before interest and taxes are paid and before non-cash charges such as depreciation and amortization are deducted out of earnings. The lower the EV/Ebitda the better! The EV/Ebitda ratio is similar to the PE ratio, but it is a slightly better way to compare company valuation since it looks at companies equally no matter how much debt they have.

There are many more ways to analyze a company’s value but this is a good starting point. Remember that professionals spend many hours of their time researching and analyzing company data. You may not have the time to become a crackerjack analyst, but you can become more comfortable in conversations about your portfolio with you advisor or stockbroker. And, who knows, maybe it is time to sell Aunt Sally’s stock bequest!