Calculating a sell price for stock is more art than science, but any science helps. The price-earnings ratio, which is used by stockbrokers and financial analysts to find the best stock to buy or sell, can also be used to compare a stock price to its intrinsic value. The intrinsic value will help to determine if the stock is overvalued or undervalued in the market, and subsequently can be used as a tool to find the best selling price.
TL;DR (Too Long; Didn't Read)
By using the price-earnings ratio to compare a stock price to its intrinsic value, you can determine the best selling price for that stock.
Market Versus Intrinsic Value
The intrinsic value of a 1925 Liberty Peace silver dollar is $1, but the market value can be $25 to $300, depending on where it was minted. Stocks operate in much the same way, so stockbrokers and financial analysts are constantly looking for deals based on this intrinsic value. The price-earnings ratio provides an easy way to make this determination.
Price-Earnings Ratio Example
The P/E ratio is calculated by dividing the price of the stock by its annual earnings. For example, if the price of stock is $50 and it earned $5 per share, the P/E ratio is $50 divided by $5, which equals 10, or a price-earnings ratio of 10-to-1.
Earnings provide a baseline for comparing the intrinsic value — represented by earnings per share — to the market value, which is represented by the stock price. What this ratio is really saying is that the stock is trading at a market price of 10 times its earnings per share.
P/E Example Calculation
Assume you've decided to purchase a stock in the financial services industry since you work at a bank. The financial services industry is performing poorly when you want to buy, so you're looking to find a deal on a company with high earnings and a low stock price. You find that the average P/E ratio for the financial services industry is 10.
Your goal is to find a company that's "on sale" — trading below the industry average P/E ratio. A company with a P/E ratio of 5 is on sale, for example, compared to a company trading with a P/E ratio of 15. If you find two financial services companies with P/E ratios of 3 and 24, the "deal" is the company with the P/E ratio of 3, whereas the company with the P/E ratio of 24 is overvalued.
Calculating the Sell Price
Assume you purchased the financial services stock with a P/E ratio of 3, and now you want to calculate the best price to sell. You need to back into the price using the industry ratio as a threshold. In this case, that threshold is 10, and earnings per share have been at $1.
If you buy the stock at $3, the P/E ratio is 3, which is calculated by dividing the price of the stock by its earnings per share, or $3 divided by $1. If the stock price goes up to $10, the new P/E ratio is 10. Since the industry P/E ratio is 10, this may be telling you that the stock is no longer undervalued and it's time to sell.
Sharon Barstow started her career in investment banking and then crossed over to the world of corporate finance as a financial analyst. She specializes in banking and corporate finance topics to include treasury management, financial analysis, financial statement analysis, corporate finance and FP&A. In addition to writing, she is the co-owner of a small dog bakery in rural Ohio.