How to Create a Stock Valuation
The Difference Between Price and Value
Buy low, sell high: how to determine whether a stock is good value in order to maximize investment returns.
Fundamental SWOT analysis and number crunching is used to eliminate high risk or unattractive stocks. It should ultimately help the investor to weed out an exciting growth company with strong underlying attractions, limited risks and weaknesses, an exceptional management team and, most importantly, lots of potential.
But there is one other important factor to think about before buying a stock.
The Valuation
As the famous economist, Richard Thaler, once said:
“Investors must keep in mind that there’s a difference between a good company and a good stock. After all, you can buy a good car but pay too much for it.”
So how are shares valued?
The price of a share is dependent on a number of factors, including the size (blue chips have less growth potential – as the fund manager Jim Slater always said, “Elephants don’t gallop”), the sector (reliable markets command higher ratings), the debt (a high level of debt is undesirable) and profitability.
PE Ratios
Profitability is reflected in the Price to Earnings Ratio (PE Ratio) which is commonly used by market analysts.
PE Ratio = Share Price / Earnings Per Share
Analysts might talk about a stock trading at a multiple of 12 times earnings; meaning the PE Ratio is 12.
In reference to small cap or growth stocks, a low PE Ratio (less than 10) suggests that there is risk associated with the investment, or that it has a limited track record. This is where stocks can be bought up cheaply; some will do well and soar in value, while others will disappoint and dive.
At this early stage, young company stocks can be a gamble. That is why it’s crucial to do thorough research and pick a stock that inspires real faith.
Mid cap and blue chip companies usually command high PE Ratios (more than 16) based on the current year’s earning potential. These stocks are not necessarily overvalued, but their reliable and steady growth prospects are priced into the stock.
Dividend Yields
As a reward, established stocks usually pay dividends to their shareholders, which create a small bonus income.
Dividend Yield = Dividend Per Share / Share Price x 100
This compares to current bank savings rates. Investing money with a bank for one year might generate 5-6% interest, risk free. But an 8% yield with a blue chip stock may be worthwhile, since this is probably the least risky type of stock market investment.
Holding Stocks
However, for many people, capital growth is the main reason to invest. That is the appreciation of a stock over several months or years.
When buying a stock, aim to hold it for a minimum of six months, ideally 1-3 years, and sometimes even longer. A solid growth business which keeps on expanding and delivering greater profits every year will deliver good ongoing returns for its shareholders.
Finally, there are many triggers for selling a stock but it is wise to monitor the valuation. If the market is too fond of a share, the price may become over-inflated and that is rarely sustained for long.
This article is part of a series. To see more, visit:
Interpreting Financial Accounts
