Pin the Value on the Stock

Conceptually, investing is easy. When you're looking at a contender for a spot in your portfolio, it's all about two simple questions:

1. Is this a high-quality company?
2. Is the stock a good value right now?

To answer the first question, you need to determine whether the company is healthy (with manageable debt and ample cash, for example) and growing. You want to see talented management, an impressive track record of performance, competitive advantages, and the promise of more growth.

The second question can be trickier. After all, even the best stock analysts and investors can't do more than come up with an educated guess about what a stock should be worth. Still, you shouldn't invest in a company, no matter its quality, if its stock price seems to have gotten considerably ahead of itself. Ideally, you want to buy at a substantial discount to intrinsic value.

One route you can take is to spend the time and energy learning how to value stocks carefully. But there's a simpler way to get an initial ballpark estimate, which will help give you a reasonable start to your stock research.

Do it yourself
Here's the quick method I use sometimes: Look up a stock's historical price-to-earnings ratios (P/E), which you can do with our Motley Fool CAPS service. (Type in your ticker and go to the tab labeled "Ratios.") Here's the data for Cisco Systems (NASDAQ:CSCO). If Cisco's P/E has been between 11 and 26 over the past five years, it doesn't look like a screaming bargain with a P/E of 23. On average, the company's P/E over the past five years has been 21.6.

Next, grab the company's expected earnings per share (EPS) for the coming year. It's sometimes called the "forward EPS." At CAPS, I learned that the average expected EPS for Cisco for fiscal 2011 is $1.38.

So now you take the expected EPS of $1.38 and the five-year average P/E of 21.6, and multiply them, getting $29.81. That's the price you might expect Cisco to be trading around in fiscal 2011, and it's more than 25% above where the stock closed yesterday.

Making sense of it
Now that's no guarantee, of course. Cisco may well surge strongly in the coming year, or it could stagnate or even fall sharply. But this is a way to get a rough idea of a reasonable value to expect. The reasoning behind it is this: The current P/E can fluctuate wildly as economic conditions change, but the average tends to stay more stable. Therefore, it's arguably a better measure for long-term investors to use.

Check out these examples:

Data: Motley Fool CAPS, Morningstar.

Looking at the table above, American Express seems to be somewhat overvalued, and Boeing seems to be significantly undervalued. The other companies seem to offer ample growth prospects.

Far from perfect
This is helpful, but it's not enough to base decisions on without taking a closer look. Boeing, for example, sports only three stars in CAPS, suggesting that many investors have reservations about it. So there may be a good reason why the shares seem depressed.  

In some cases, a stock's average P/E might be somewhat high due to its having soared for a while in recent years. Its expected earnings per share, too, might be higher or lower than one would normally anticipate, perhaps due to some extraordinary events. Remember, too, that EPS can be managed to some degree, as accounting rules permit some leeway.

So use this system to help you get a rough idea of a stock's current valuation. Don't, however, rely on the method too much.

If you're a value investor, now's a great time to be shopping for stocks. Jordan DiPietro has some great stock ideas just for you.