The most difficult aspect of investment is knowing when to buy and when to sell.
The only way to truly know whether an investment is worthwhile or not is to take advantage of valuation methods.
There are number of basic valuation methods that are regularly used in finance to quickly assess the value of a company.
The most commonly discussed valuation method is the price-to-earnings ratio.
If you ever listen to finance professionals talking about the value of a company in a casual environment, you’ll definitely hear them talk about the P/E ratio of the stock.
The price-to-earnings ratio is fairly easy to understand as it refers to the amount of money that an investor pays for each dollar that a company makes.
For example, if the P/E ratio of a company is 10, investors are paying $10 for every $1 that a company earns.
When it comes to investing, the standard P/E ratio is 20, which means that investors should usually expect to pay $20 for every $1 earned by a company.
The P/E ratio can be used to interpret the future performance of a stock.
Stocks with high P/E ratios are expected to perform strongly in the future, while stocks with low P/E ratios are expected to not perform so well.
This is not always the case but is considered to be a general rule.
Investing in companies with low P/E ratios is called ‘value investing’. This is the case because investors that invest in companies with low P/E ratios are hoping to get a lot of bang for their buck.
Warren Buffett is the most famous value investor, though his strategy has changed in recent years. His belief now is that it is better to buy fantastic companies at fair prices.
When investing, it’s important to have a margin of safety. This basically means that it is preferable to invest in companies where the P/E isn’t extremely high as the stock price will fall drastically if something goes wrong. In this case, an investor would lose a lot of money.
Amazon is notorious for having a high P/E ratio, which is regularly in the region of 120. This means that investors are paying $120 for every $1 that Amazon earns, which a lot of investor would feel uncomfortable with.
Similar to price-to-earnings ratios, price-to-book ratios give you an idea of how much you are paying for a stock compared with the underlying performance of the company.
Price-to-book ratios are different, however, because they focus primarily upon the value of the assets and liabilities of the company.
Price-to-earnings ratios, on the other hand, focus solely on the earnings of the company, which doesn’t necessarily give you the full picture.
The book part of the ratio tells you how much the company is worth when you subtract the total liabilities of a company from the total assets.
For example, if a company has $20,000,000 in assets and $5,000,000 in liabilities, the book value would be $15,000,000.
This then needs to be divided by the total number of shares outstanding so that it can be used in the P/B ratio.
If a company has 1,000,000 share outstanding, then this figure would be $15.
If the stock price is $20, you’d then do $20/$15, which is 1.33 – the P/B ratio. From this, we can say that investors are paying $1.33 for every $1 of book value.
A P/B value below 1 is considered good as the company undervalued, but investors will usually consider companies with a P/B ratio that is less than 3.
P/B ratios shouldn’t be used on their own to assess the worthiness of an investment. This is because a low P/B ratio can represent fundamental problems with a company.