INSIDE INVESTOR: How to tell if a stock is cheap or too expensive

Before investing in equities, it's important to determine the relative value of a stock to find out if it's overpriced. The PE ratio is an easy method to use.

Our share market may be stuck in the doldrums, drifting between 5,000 and 5,500.

But that listless overall performance masks some recent hectic activity. In fact, some of our stocks, and particularly our banks are among the most expensive in the world.

Surely not. How could that possibly be the case when there are bigger banks elsewhere and when markets like Wall Street just a few weeks back were threatening to break new records while the Australian market is sitting around half its 2007 record.

It all depends on how you measure expensive. Of course there is the face value of the shares themselves. But that won’t tell you much.

Take BHP for example. It is valued on the market at around $167 billion. But if there was only one share on issue, and you wanted to buy it, that would set you back, that’s right, $167 billion. If there were two shares, you’d halve that.

So the face value of the shares depends heavily on the number of shares on issue.

A much better way to measure the relative price or value of a stock is to look at its price and then divide that by its earnings. This is called the price/earnings ratio and it is a measure that neatly sidesteps the tricky question of the number of shares a company has out in investor land.

Like all good finance terms, it’s been whittled down to an acronym, just to confuse you, and these days is universally known as the PE ratio.

It can be easily calculated in two ways. Look at BHP again. The company’s price is $167 billion. It last year earned $14.77 billion. Take the price and divide it by the earnings. You end up with a price earnings ratio of 11.33.

The other way to calculate it is to use the share price and divide by the earnings per share. It is the same calculation, it is just that this is done on an individual share basis.

So the result is the same.

Now compare that price earnings ratio to that of one of our big banks, NAB. It is trading on a price earnings ratio of about 10.5. That means NAB is cheaper than BHP.

One thing to be careful of when using these comparisons is that many traders and stock brokers calculate their PE ratios using estimates of next year’s earnings rather than last year’s. That’s because smart investors always look ahead to guess the trends, rather than look at history.