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.
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.