How To Tell If A Stock Is Cheap Or Expensive

Last week during Christmas, I was out with some friends when I got a question from one of them: “The market seems to be so frothy now. How are you investing?”

I believe the question is probably on the minds of quite a few investors out there. After all, Singapore’s stock market benchmark, the Straits Times Index (SGX: ^STI), is up by over 14% compared to the lows seen this year that was set back in late January.

But, the price of a stock alone provides no information on whether it is expensive or cheap. This holds even if one were to compare a stock’s price across time.

So, let’s look at how investors can determine if a stock is actually cheap or expensive.

There are numerous valuation metrics investors can use to make sense of how expensive or cheap a stock is currently. Some examples of such valuation metrics include the price-to-earnings (PE) ratio, price-to-book (PB) ratio, price-to-free cash flow (PFCF) ratio, and dividend yield.

The thing about valuation metrics is that, on their own, they probably can’t tell you much either.

But, they can be compared to historical data. For example, a stock currently trading at a PE ratio of 25 doesn’t tell you much. But if you know that the stock’s peak PE over the past few years was 45 and the low was 20, it tells you that the stock is trading at the lower end of its historical valuation range. And, that might make the stock worthy of consideration.

Another way to use valuation metrics would be to compare a specific stock’s metrics with the average across its industry. This can tell you if the stock is over or underpriced when compared to its industry peers. But do note that an entire industry could be overpriced or underpriced, so it’s important to account for that as well when performing peer comparisons.

It is also important to ensure that the correct metrics are used. This is because certain metrics are better suited for certain types of companies. For example, someone looking at real estate investment trust (REITs) should be focusing more on the PB ratio and dividend yield rather than the PE ratio.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.