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price/earnings (P/E) approach stock valuation approach that tries to find the P/E ratio that's most appropriate for the stock; this ratio along with estimated EPS, is used to determine a reasonable stock price.

One of the problems with the stock valuation procedures we've looked at above is that they are fairly mechanical. They involve a good deal of "number crunching." Although such an approach is fine with some stocks, it doesn't work well with others. Fortunately, there is a more intuitive approach. That alternative is the price/earnings (or P/E) approach to stock valuation.

The P/E approach is a favorite of professional security analysts and is widely used in practice. It's relatively simple to use, because it's based on the standard P/E formula first introduced in Chapter 7 (Equation 7.14). There we showed that a stock's P/E is equal to its market price divided by the stock's EPS. Using this equation and solving for the market price of the stock, we have

Equation 8.12

Stock price = EPS X P/E ratio

Equation 8.12 basically captures the P/E approach to stock valuation. That is, given an estimated EPS figure, you decide on a P/E ratio that you feel is appropriate for the stock. Then you use it in Equation 8.12 to see what kind of price you come up with and how that compares to the stock's current price.

Actually, this approach is no different from what's used in the market every day. Look at the stock quotes in the Wall Street Journal. They include the stock's P/E and show what investors are willing to pay for one dollar of earnings. The higher the multiple, the better investors feel about the company and its future prospects. Essentially, the Journal relates the company's earnings per share for the last 12 months (known as trailing earnings) to the latest price of the stock. In practice, however, investors buy stocks not for their past earnings but for their expected future earnings. Thus, in Equation 8.12, it's customary to use forecasted EPS for next year.

To implement the P/E approach, the first thing you have to do is come up with forecasted EPS one year out. In the early part of this chapter, we saw how this might be done (see, for instance, Equation 8.3). Given the forecasted EPS, the next task is to evaluate the variables that drive the P/E ratio. Most of that assessment is intuitive. For example, you might want to look at the stock's expected rate of growth in earnings, any potential major changes in the firm's capital structure or dividends, and any other factors such as relative market or industry P/Es that might affect the stock's multiple. You could use such inputs to come up with a base P/E, and then adjust that base, as necessary, to account for the perceived state of the market and/or anticipated changes in the rate of inflation.

Along with estimated EPS, we now have the P/E we need to compute (via Equation 8.12) the price at which the stock should be trading. By comparing that targeted price to the current market price of the stock, we can decide whether the stock is a good buy. For example, we would consider the stock undervalued and therefore a good buy if the computed price of the stock were more than its market price.

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