The most popular valuation ratio is Price to Earnings, or “PE.” As stated in previous posts companies tend to trade within a range of PE values so if one can reasonable predict future earnings one can also predict future prices and evaluate potential returns. Of course a simpler method would be to simply use PE as a buy criteria where stocks are purchased when within the low side of their PE range. Of course, this should be done using a set of stocks that have been pre-selected for their fundamental properties such as sustained earnings growth rather than being used as the sole criteria for the purchase. Many stocks have a low PE for a reason.
Some companies, however, may not always have positive earnings. While the fundamental theme of this blog is long-term investing, which would not involve investing in companies that lose money periodically, use of other valuation measures is useful for those who do wish to dabble in these stocks for entertainment value if nothing else. Certainly, one can garner a handsome return in cyclical stocks such as air lines, steel makers, and semiconductors by buying when the stocks are in the down portion of the business cycle and then selling during the up portion. For times like the present where the market isn’t really going anywhere, this can also provide current income.
The two other valuation measures are Price to Sales, or PS, and Price to Book Value. Price to sales is just the stock price times the number of shares (the market capitalization) divided by gross revenues. Because virtually all companies will have positive sales figures, this ratio will always exist. A second ratio is the market capitalization divided by the book value, which is the value of assets of the company (machines, land, building) that could be gained if the parts of the company were simple sold off. Once again, this value will not normally be negative and always exist.
The trick here is to review the history of the company and see what the range of the factors is. (Also, pick companies that are probably not going to go under during the next recession – those that are reasonable strong financially, mainly the leaders in the market sector.) Set a low limit, which is the buy point, and a high limit which is the sell point. If you set the limits towards the middle of the range you will buy and sell more often, incurring more taxes and fees but getting more entertainment. Setting the limits near the outsides of the range will result in less frequent trades but will also miss some of the smaller movements. A study of the two techniques for many companies (see the excellent piece by Cypress Semiconductor CEO TJ Rogere, “Thinking of Cypress Stock,” at their website http://www.cypress.com/?rID=35390) the return for the two strategies will be about the same before taxes and fees, so using a larger range would be preferable.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.