I think what confuses and potentially intimidates people about buying stocks is the risk or uncertainty of how they will perform. People hear stories of how their friends buy stocks, and even though the companies do well, the stock price decreases in value. That happens when the overall market thinks the company is not going to meet future expectations, even though they have met past ones. You see, there are two components of the value of a stock. The first component is what's on paper, i.e. the earnings, profit, operating costs, revenue, etc. The second component is the estimate of potential growth, which is a bit more hazy, as nobody can really predict the future entirely.
This second component of the stock value can be ascertained through several ways, namely the company's own forecasts, the expectations of third party financial analysts, and even the borderline speculative ideas we talked about in the previous post, e.g. "Apple will take over the smartphone market with it's Iphone." Professional analysts come up with their estimates via various methods, including polls, very complex mathematical models, and talking with company insiders. I've listened to a lot of analysts' arguments, and I have yet to find one where I didn't think was subjective in a way.
You can probably ascertain that, in my opinion, the more dependable data in terms of valuing stocks is the factual and objective data of a company. Like I said in the last article, estimates and predictions of a company's future can be useful as perhaps a catalyst, but the foundation of valuing stocks should be the company's actual performance. In addition, if a company has historically performed well, they most likely will continue to do so.
OK, so you need to look at the objective facts. What are they? The most important piece of data you should examine is the Price to Earnings ratio (P/E ratio). The P/E ratio is the stock price divided by the annual earnings per share. Sounds like a bunch of calculus, right? Well, the good thing is you don't really have to remember this formula, but you just have to know how to use it. The P/E ratio gives you an idea of how much you are paying for a company's profits. Let's say for the last 12 months, a company has made a profit of $1000. The company has 10,000 shares, so its earnings per share would be ten cents. If its stock price is $5, then its P/E ratio would be 50. In another words, you're paying $50 for every $1 the company makes. If that sounds like a lot, you're probably right. Most people consider a company fairly valued with a P/E ratio around 15-20, but the P/E ratio is also industry and history dependent. For example, an industry like the technology sector generally has higher average P/E ratios. So if you're buying a company like Microsoft, you need to compare its P/E ratio with other big software companies.
Also keep in mind that every company is unique in how it grows, so you also need to look at historical P/E ratios. A good website among others to do that is Forbes.com. As an example, let's look at the historical P/E ratios of General Electric.
Current P/E Ratio 13.1
P/E Ratio 1 Month Ago 13.4
P/E Ratio 26 Weeks Ago 15.3
P/E Ratio 52 Weeks Ago 18.5
5-Year High P/E Ratio 24.2
5-Year Avg. High P/E Ratio 21.5
5-Year Low P/E Ratio 13.7
5-Year Avg. Low P/E Ratio 16.9
5-Year Avg. P/E Ratio 20.3
You can even go back further on your own, but just looking at these values, you can see that GE is the cheapest than it's ever been in the last 5 years. And when we look at similar companies, the industrial average is about 16. So then should you buy GE now? Yes, GE is a great buy right now, but let's examine my last point about P/E ratios before we make the decision.
You may have heard recently that the stock market is a "bear" market. This means that the Dow Jones Index has lost at least 20% of it's value from it's most recent highest point. (The term "bear" is used to define a pessimistic investor, whereas an optimistic investor is called a "bull.") A bear market usually reflects a time of economic downturn. Most recent bear markets were the collapse of the silicon valley bubble, the savings and loan crisis in the 80's, and the oil crisis in the 70's. The reason I bring up the bear market is that in such a market, P/E ratios are often reset to lower values. This is because there is a general market-wide loss of confidence. So if you decide to invest today, you would probably benefit from lowering the P/E standards a few points. Going back to our example with GE, you can certainly buy it now, as it is very cheap compared to its historical value. However, because we are in a bear market, it may be wise to have a lower P/E standard, i.e wait until the P/E ratio approaches 12.
But what if the P/E doesn't reach 12? Well, if you are set on buying GE, you can establish an upper limit for a fair value. The 5 year average P/E for GE is 20, but the industry average is 16, so I would say you could use the level of 16 as the upper limit to make sure you buy GE at a fair to discounted value. If the P/E ratio starts going up, you can make sure to buy before it reaches 16. So you see, it's not calculus after all.
One last thing before you pull the trigger though. Try to get to know the companies you buy as much as you can. What are its products? Who are the main management personnel? How much business does it do overseas? What have been its growth rates in the past? What are the company's business strategies going forward? I've touched some on the importance of this research in previous posts. Again, all this info can be found on the web. Essentially, I want to make sure you have a good grip on the companies before you buy them.
Alright, so the moment has arrived for you to set up your portfolio. However, it's not as simple as setting it up and then holding onto to it for a long time. In the next post, I'll go over how to MAINTAIN your portfolio. Til then, make you make some moolah!
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