Two Fresh Ways to Gauge the Value of a Stock

For years, the price-to-earnings (P/E) ratio has been the go-to gauge of a stock’s value, but it may be losing its mojo. The P/E ratio compares a company’s current share price to its earnings per share. It is calculated by dividing market value per share by estimated earnings per share. The lower the P/E ratio, the cheaper a stock, in theory.

The problem with the P/E ratio in today’s economic environment is that the earnings can’t always be trusted. Corporate earnings estimates, say many analysts, are unrealistically high.

As a result, investors may want to seek other ways to value stocks that are quite removed from corporate earnings.

For example, investors may want to look at two other valuation measures, like enterprise value and free cash flow.

Enterprise value is a figure that values a company based on its entire capital base, which includes short- and long-term debt, preferred stock and minority interests, minus total cash.

Free cash flow is a figure that takes a company’s earnings and subtracts capital expenditures.

Because it reveals the amount of cash a company is able to generate after spending the money necessary to maintain or expand its asset base, it gives investors an idea of a company’s ability to boost dividends or buy back shares.

If you invest in stocks, your financial advisor can help you determine which ones are appropriate for you, based on a number of financial measures.