How To Know When a Stock is Expensive

I recently saw a comment on one of the stock market chatrooms about a stock that was trading at $105 a share. The poster said, “this stock is going to come down. It’s just too expensive for anyone to buy at this price.”

But was it? The poster was alluding to the $105 price of the stock and not the underlying fundamentals of the stock (how much money the company was earning, how much it was spending, its growth prospects etc.)

It has been thought in the past that companies will split their stock once it goes over $100 a share as that has historically been the point where it was considered “too expensive” for the regular investor to afford it.

But that concept (of the split to keep the share price down) seems old school now with multiple stocks trading over $100- including some of the most popular companies like Google.

Some well-known companies that trade over $100:

Berkshire Hathaway A Shares: $117,200
Berkshire Hathaway B Shares: $3913
Boeing: 105.46
Chipotle: 119.26
John Deere & Co: 147.39
Energizer: 110.26
FedEx: 104.64
Goldman Sachs: 216.78
Google: 567.50
IBM: 117.71
Mastercard: 148.00
Toyota: 115.88
United States Stee: 106.04
Washington Post: 804.01

By purely price standards, all of these stocks are “expensive.” To buy 10 shares of Boeing, would cost you over $1000.

But with stocks you have to look beyond the actual share price to determine whether a stock is actually priced right. It is sometimes difficult to do. John Deere, for instance, certainly seems really pricey at $147 a share. You have to look beyond the $147 to really determine its value.

How to Find a Stock’s Value

I use MSN Money for my financial data because that website provides easy to understand data on a company’s financial condition.

Put in the ticker for Deere & Company, which is “DE” in the symbol box at the top of the page.

It will give you a quote for DE. On the right are some categories that will help you determine whether a stock is “expensive.”

The first category is Price to Earnings or P/E. For Deere & Co. the quote states 20.10. For P/Es, the lower the number, the “cheaper” the stock. This is telling me that Deere & Company is trading at 20 times the P/E which isn’t horribly expensive. The overall S&P 500 is trading at 17 times earnings (has a P/E of 17.) Historically, the S&P 500 has traded around 16 times earnings. With these guidelines, we can conclude that DE is not super cheap- but it’s not out of sight expensive.

Another interesting category to consider on that same page is the Return on Equity or ROE. Not all stock quote pages give you this information but it is very valuable to have in determining the “value” of a stock. From Investorwords.com:

ROE. A measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year’s after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage. It is used as a general indication of the company’s efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. Investors usually look for companies with returns on equity that are high and growing.

Huh? Does this sound like a foreign language to you too? Don’t despair.

Remember ROE this way: Warren Buffett doesn’t invest in a company unless the ROE is consistently over 12.

Is Deere & Company “expensive”?

We already see that DE has a P/E of about 20. It’s return on equity is 21.45, which is excellent. Based on these two factors, it doesn’t appear that DE, which is trading at $147, is all that expensive.

Let’s consider another company on the list of high priced stocks.

Is Chipotle “expensive”?

Chipotle’s stock has been hot since it’s spin-off from McDonalds a few years ago. The company is rapidly expanding and many investors are betting on continued growth.

According to the stock quote, Chipotle’s (CMG) P/E is 71.40. Wow! Seems really high. MSN Money also tells you the “forward P/E” (that is looking ahead a few quarters) and that number is 59.00, also really high.

But this stock is a fast grower- which means that it is growing its earnings so fast, some investors think it will be able to keep up with the share price.

Now let’s check out the Return on Equity, or ROE. It is 11.71. That is just below Mr. Buffett’s ROE of 12 cut-off. If you actually dig deeper into the companies numbers, you will find out that the Return on Equity for the last few years is not great.

On the left hand column of the page you will see a link for “Financial Results.” Click on that. Look at the left hand column again. Under the “Financial Results” link is a link for “Key Ratios.” Click on that.

Now- one more click.

In the middle of the page is a list of links, click on the one that says “Ten Year Summary.”

You can see the Return on Equity for the last ten years on this chart. Chipotle is a new company and only has information for the past three years. The chart for ROE states:

2006: 8.7%
2005: 12.2%
2004: 2.3%

Buffett believes the ROE should be over 12 consistently- year in and year out. You can see from these numbers that Chipotle doesn’t cut it.

Is Chipotle too expensive at $119? The answer would be “yes.”

Stocks are not a pair of jeans. A pair of jeans may seem really expensive at $150, but a stock may not be. You have to train yourself to look beyond the share price. $1000 of Deere & Company may be a better investment, even at $150 a share, then $1000 of La-Z-Boy (trading below $8, but having a very difficult time selling its product in this down housing market.)

Look beyond the “price” of the stock when investing.