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How Much Should You Pay for a Stock?

With stock prices going up and down all the time, how do you decide when to buy a stock? Specifically, how much should you pay for a stock?

Just like shopping at the local market, where quality merchandises tend to be more expensive, quality stocks tend to be priced at a premium as well.

At most, pay a fair price for quality stocks

One quick and simple way investors can identify quality stocks is by their A-grade ratings from credit-rating agencies. Canadian National Railway (TSX:CNR)(NYSE:CNI) has an S&P credit rating of A. Additionally, its earnings per share have increased over the long run (+20 years), which means the company is becoming consistently more profitable over time.

At the recent quotation of under $95 per share, Canadian National Railway trades at a price-to-earnings ratio (P/E) of ~18.8, while the analyst consensus at Thomson Reuters estimates the company will grow its earnings per share by 10.2% per share for the next three to five years.

Reuters has a mean 12-month price target of $109 for Canadian National Railway, which indicates the company is trading at a discount of ~13%. So, the stock is reasonably priced.

Demand a bigger discount from B-rated stocks

Altagas Ltd. (TSX:ALA) has an S&P credit rating of BBB, which is one notch higher than the minimum rating to be considered investment grade. For B-rated stocks, investors should demand a bigger margin of safety before buying.

At the recent quotation of ~$24 per share, Altagas trades at a P/E of ~21.1, while the analyst consensus at Reuters estimates the company will grow its earnings per share by 15.8% per share for the next three to five years.

This seems like a pretty cheap stock. However, there’s more to the story. Like most other North American energy infrastructure company stocks, Altagas is sensitive to interest rate hikes because of the debt-heavy nature of the business.

Moreover, the stock is currently weighed down by the WGL Holdings acquisition. To partly fund the huge acquisition, Altagas is considering +$2 billion of asset sales, which brings in uncertainty — can Altagas find buyers who will pay a good price for its assets?

Reuters has a mean 12-month price target of $28.80 for Altagas, which indicates Altagas is trading at a discount of ~16%. Value investors might demand a discount of 30-50% before considering the stock. This way, there’s a bigger margin of safety to limit the downside.

Investor takeaway

Whether you’re looking to buy an A-grade or B-grade company, the lower the valuation you pay, the more limited the downside is, because when the stock is trading at a cheaper price, some risks have already played out.

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Fool contributor Kay Ng owns shares of Altagas. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Altagas and Canadian National Railway are recommendations of Stock Advisor Canada.

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