It’s a combination of part science, part art, understanding how stock valuation works can help you discover trading opportunities. Our partners over at Charles Schwab broke it down in this helpful article…
The biggest question in investing is whether the stock market—or a sector, industry, or specific stock—is going to go up or down in the months ahead.
“I don’t blame anyone for asking that question,” says Brad Sorensen, Director of Market and Sector Analysis at the Schwab Center for Financial Research. “It’s the one we all want answered.”
Of course, no one knows for sure which direction the stock market will go—especially in the short term. That’s because a wide number of variables, many of which can’t be predicted, can make the markets move in one direction or the other and render useless even the best research and analysis. These variables can include regulatory changes, extreme weather or natural disasters, changes in management—the list goes on.
That doesn’t mean investors can’t make intelligent, informed guesses. While no one can predict the market’s exact ups and downs, investors have the potential to boost their investment returns over the long term if they can identify sectors or stocks that are undervalued or overvalued.
Valuing the Market
At any given point in time, the stock market’s value is the sum of all of the shares outstanding multiplied by their prices. If we all agreed that this value was fair, then stock prices would be static, stuck in place until an outside variable—say, the release of new economic data—changed investors’ minds.
But the reality is that we don’t all agree, and that’s why there are so many ways to value the market. One is to compute the value of the entire stock market (total market capitalization) relative to U.S. gross national product.
Another way is the Q ratio. It starts with total market capitalization and divides that number by the replacement cost, or the amount of money a company would have to spend to replace an asset, added up across all companies and industries.
A third method, used by Morningstar, calculates fair value assumptions using a proprietary discounted cash flow model. The model assumes that each stock’s value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. Tallied up, these individual valuations help determine whether the market as a whole is over- or undervalued.
Evaluating Individual Stocks
Many investors look at common, well-known metrics to determine how a stock is likely to perform. One of investors’ most widely used tools in this respect is the price-to-earnings (P/E) ratio—the measure of a stock price compared to its per-share earnings.
“The P/E ratio is a familiar metric for many investors, as there tends to be a lot of information out there about earnings,” Brad says. “But it’s far from being a perfect measure, and it’s only one piece of the puzzle.”
For example, many P/E ratios are retroactive measures—meaning they reflect a current price against a trailing 12-month profit. That’s useful, but investors generally aren’t buying a company’s past. Instead, they are investing in the future, trying to capture growth.
Price-to-book (P/B) ratio is another popular tool for measuring the price of a stock or index against its per-share book value (total assets minus intangible assets and liabilities). A low P/B ratio—typically less than 1—could indicate that a stock is undervalued. This metric is popular among value investors, who search for securities that trade below their intrinsic net worth.
But, like P/E ratios, P/B ratios have their limitations. For instance, a P/B ratio tends to be more useful for companies with a lot of hard assets on their books, such as factories or equipment. The ratio says less about companies with significant non-physical assets, such as intellectual property and brands.
Brad says that it’s not wrong for investors to consider P/E or P/B ratios as part of their research, but that they shouldn’t rely on this data alone. There are plenty of metrics—such as cash flow and debt ratios—that an investor can use to measure value. Brad also recommends that investors pay close attention to sales growth—especially in today’s market.
“Many companies stayed afloat during the recent market downturn by cutting costs everywhere they could,” Brad says. “Going forward, companies will have to rely on sales growth in order to maintain viability and profitability.”
For sector analysis—the area that Brad focuses on—determining trends means incorporating macro-economic data points and other factors that might impact a particular industry. When analyzing the technology sector, for example, Brad and his team track the age of current equipment and whether companies have the cash to invest in new technology. They also examine whether the environment is favorable for financing purchases.
Some sectors—such as financials, which include banks, investment firms, mortgage companies, and insurers—are more complicated than others to analyze. “These businesses are vulnerable to regulatory and interest rate changes, and even natural disasters,” Brad says. “There are hundreds of data points to consider.”
While it’s important to look ahead in an attempt to gain insight into where a company or sector is heading, Brad suggests investors pay attention to historical valuation levels.
“It’s critical to look at investments relative to how they have traded and performed at different points during economic cycles,” he says. “An investment’s past performance doesn’t guarantee its future returns, but historical data can provide clues as to what might happen.”
As a result, Brad and his team constantly update valuation models and forecasts based on incoming economic data, and—at least monthly—look back in time to see if a stock or sector is trading in a pattern that could help inform future movement.
“It’s a juggling act—looking back and evaluating possible future scenarios simultaneously, and taking in as much information as possible to help make informed decisions down the road,” he says.
Making Sense of the Data
With so many different data points to consider, some investors might find it difficult to track down and synthesize information about a specific investment or a particular area of the market. Brad Sorensen and his colleagues at the Schwab Center for Financial Research spend much of their time evaluating and rating stocks and sectors in order to provide Schwab clients with objective, comprehensive research to help them make informed decisions. One result of their efforts is the collection of approximately 3,000 Schwab Equity Ratings®. Available to Schwab clients, these A-F grades can help condense and simplify large amounts of data based on a 12-month outlook.
Though no one can consistently and accurately predict what the market does next, knowing how stocks are valued can help you find opportunities. By identifying sectors or stocks that are undervalued or overvalued, you may be able to boost investment returns over the long term.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Investing involves risk, including loss of principal.
Sector investing may involve a greater degree of risk than an investment with broader diversification.
Schwab Equity Ratings use a scale of A, B, C, D and F, and are assigned to approximately 3,200 U.S.-traded stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. Schwab’s research outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months.
Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Schwab Equity Ratings should only constitute one component in your own research to evaluate stocks and investment opportunities. From time to time, Schwab may update the Schwab Equity Ratings methodology. Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.
Schwab Industry Ratings provide Schwab’s outlook for industries based on Global Industry Classification Standard (GICS®) groupings, such as Beverages, Pharmaceuticals and Software. Schwab Industry Ratings are assigned using an A, B, C, D and F rating scale and can be particularly helpful in evaluating which industries investors may want to emphasize within a specific sector. They can also be used in conjunction with Schwab Equity Ratings to help fill in gaps in a portfolio. See Schwab.com for more information.
Past performance is not indicative of future results.