Valuation matters

Q

How does one determine a stock’s real value? — C.F., Chubbuck, Idaho

A

You’re right to note that a stock’s current price is not necessarily equal to its intrinsic (sometimes called fair) value. Overenthusiastic investors may have bid the price up into overvalued territory, or it may be languishing at an undervalued level due to a lack of investor interest or confidence. Seeking and investing in undervalued high-quality companies is a smart strategy.

Determining a stock’s fair value is easier said than done, though, and skilled analysts will often arrive at different estimates. Some will use complicated “discounted cash flow” analysis, estimating future free cash flows and assigning them present values based on chosen discount rates. (In other

words, this will still be an educated guess.)

Most of us individual investors favor simpler ways to estimate a stock’s valuation. The price-to-earnings (P/E) ratio, which divides the current stock price by the last 12 months of earnings per share, is one of many useful tools: The lower the P/E ratio, the more attractive the price. (Though it’s important to remember that P/E ratios vary by industry.)

Don’t rely on any one valuation or stock assessment method alone, though. Dig deeply into any company you’re considering for your portfolio.

Q

How large are “large-cap” companies, and how small are “small-cap” ones?

— P.J., Tarentum, Pennsylvania

A

There’s no single definition, but here’s a common one: Consider companies with market capitalizations below $300 million to be micro-caps; between $300 million and $2 billion, small-caps; between $2 billion and $10 billion, mid-caps; between $10 billion and $200 billion, large-caps; and above $200 billion, mega-caps.

For some current examples, Wendy’s is a mid-cap, while Starbucks is a large-cap and Pfizer a mega-cap.