Have you ever wondered how you can tell if a stock is selling at a good price? Financial programs and magazines are always saying that this stock is cheap or this stock is expensive. How do they arrive at these conclusions? Today, we are going to take a look at a few important metrics to determine when a stock is a buy or not.
The price-to-earnings ratio (P/E ratio) is the most important measurement of whether a stock is an attractive buy or not. The P/E ratio is the measure of a stock’s share price divided by its earnings-per-share. Company P/E ratios should always be compared against the average P/E for the industry.
Never compare P/E ratios across industry lines. Technology stocks, retailers, and restaurant stocks trade at higher P/Es than consumer staple and utility stocks. If the P/E ratio is lower than the industry average, the stock may be a compelling investment opportunity. If it is higher than competitors, it may be expensive. Look for companies whose current price to earnings ratio is below its historical P/E.
Pay particularly close attention to a company’s growth rate.
Billionaire value investor Warren Buffett loves to buy shares of companies that are increasing earnings. Buffett looks to invest in companies with at least 5 consecutive years of revenue growth. Look for stocks whose growth rate is equal to or higher than its P/E ratio. Stocks with high growth rates like Apple and Amazon trade at much higher P/E’s. Investors are often willing to pay more for growth. Stocks with lower growth rates like Microsoft and Walmart trade at lower P/E’s. A good rule of thumb to follow is to never pay more than 2 times the growth rate for a stock. This means that if a stock has a 6% growth rate, the maximum P/E should be 12.
Benjamin Graham, Warren Buffett’s mentor, always taught that the book value of a stock was an excellent measurement of its true value.
Graham believed that investors should look to pay no more than 1.5 times a stock’s book value. If a company’s book value is $20 then the maximum that an investor should pay is $30. Companies trading below one and a half times book value are deemed to be value stocks. Companies trading higher than one and a half times book value should be considered expensive.
If you want to learn a lot about a company, read the balance sheet. The balance sheet will tell you everything that you need to know about almost any company.
Financial stocks are the only exception because they hide many of their liabilities off of the balance sheet. The balance sheet helps you gauge the financial health of a company by looking at the assets and liabilities. Companies with huge cash warchests and low levels of debt are an investors dream so these companies often trade at premiums to other stocks. Companies with large amounts of debt and low free cash flow can masquerade as value stocks because of their lower P/E’s. Companies with high debt burdens are much more likely to go bankrupt during economic downturns than well capitalized companies.
Now you’re ready to start investing. Remember to look for companies with the following characteristics:
- A P/E ratio lower than the industry average.
- Five consecutive years of earnings growth.
- Trading at a price that is lower than 1.5 times book value.
- Two times the amount of assets to liabilities.
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What about you? What do you think are the most important criteria to look for when valuing a stock?