How to Value a Stock

By John Greenwald

Last week's frightening plunge has forced investors to ponder--some for the first time--just how to determine what a stock is worth.

There was little doubt for the generations of Americans that hewed to the teachings of Benjamin Graham and David Dodd, the legendary prophets of value investing. In the 1930s they preached that the price of a company's stock should be tightly pegged to its profits--the famous price-to-earnings ratio, or P/E, derived by dividing a stock's price by its earnings per share. The dividend yield (the payout as a ratio of the stock price) also mattered. On that basis, stocks have been getting increasingly expensive. The P/E of stocks in the S&P 500 index has climbed from an average of 13 in Graham and Dodd's time to as much as 30 in recent years. The yield has practically disappeared.

New-economy types have argued that the value metric is no measure for stocks of dotcoms like Amazon that have no earnings but just might become the next Microsoft or Dell. Their solution: simply replace the E in the ratio with something else--revenues, cash flow, new orders or what have you. And if the company should be a fast-growing market leader, or the kingpin in a field with barriers to entry, the P/E ratio could top 100 and analysts would still be calling it a buy. Until recently, they had a case; value investors missed out on the NASDAQ's huge move last year.

Now value valuators are stirring again. The Graham and Dodd model is still relevant, and the siren song of momentum investing sounds like something heard before. "We had a similar problem in 1929," says Yale economist Robert Shiller, author of Irrational Exuberance, which explores the perils of the present market. "People said then that the old standards for valuing stocks were irrelevant because we were in a new economic era."

--By John Greenwald