Stock value is an important skill to learn so that you can accurately determine a stock’s valuation. We show you proven models that have used over the years. For decades, value investors enjoyed returns in excess of 17% while their counterparts in the growth camp suffered slightly lower returns averaging only 16%+. However the tide shifted in the last decade where growth returns outpaced value by nearly 7%, 32% to 25.4%. Perhaps in light of the market collapse of 2000, it’s time to revisit both the investment philosophies and the tools each uses to determine target investments.
Value investors purchase only companies with real assets and solid current earnings and at discount prices. They look for stocks that are low-priced, compared with various measures of what the company might be worth. Just how cheap a stock is depends on how the investor measures value. One key metric is the price/earnings (P/E) ratio, which compares stock price with current or predicted earnings per share.
Price-to-earnings ratio (P/E) is the market’s summary opinion of a stock’s prospects. Many value money managers use P/E as a first level screen for companies that they are considering for investment. All else being equal, companies perceived by the market to grow and have higher earnings in the future would have higher P/Es than deteriorating companies. Rather than being an absolute measure, P/E is a relative valuation method commonly applied to identify stocks that are attractive or unattractive relative to a benchmark. A common benchmark is the S&P. For example, the average S&P stock is trading at 25 times predicted earnings. Value investors search for stocks whose P/Es drop below that average.
Also, many value investors use P/E to value common stock indirectly. For example, PE can be a better indicator of value than the price of a stock. A $10 stock with a P/E ratio of 40 is said to be much more “expensive” than a $110 stock sporting a P/E ratio of 7. The $10 stock’s future earnings stream is what the investor is paying for. The $10 stock might be a small cap company with a promising new product competing in a sector with few competitors. The $110 stock might be a more mature company with more predictable prospects. Whether P/E is high or low depends on a number of factors such as the company’s growth rate and its industry, all of which are taken into consideration by value investors prior to committing funds.
Value investors secondarily analyze dividend yields and book value per share, but always in relation to the current value of the company relative to fundamentals. Growth investors, by contrast, focus on earnings and stock prices that are growing quickly. Their potential rather than their performance characterize growth stocks. These stocks have P/Es that are typically well above average. As long as future profit growth looks strong, these stocks rise even more.
Growth companies often have not yet achieved positive earnings. Thus, growth investors focus less on P/Es and other fundamental bottom line numbers. Instead growth advocates are top line driven. The idea being that top line propels bottom line. In other words, if you have revenue then earnings will come. Sales growth, revenue trends and market share reign supreme.
Growth stocks are often new companies in new industries exploring new markets. With earnings absent, a new standard is required. As a result, some non-traditional metrics are often used to “score” these companies. For instance, Internet companies are often valued by growth measures such as eyeballs, unique monthly visitors, cost per customer and so on; biotech companies are evaluated by research and development investment; and so on.
Both growth and value investing are fundamentally mentally based. In contrast, some investors are technically oriented traders. Technical analysis is a bit like astrology in that its chart driven. However, instead of interpreting the position of the starts, technical analysts focus on movements in stocks’ trading activity. The assumption is that charts can indicate, indeed predicate market psychology, unlocking movement trends in both individual securities as well as the macro environment. Technical traders use a variety of tools including point and figure charts, Japanese candlesticks, and logarithmic derivations.
Whether growth, value or technical theoreticians outperform the markets to come is yet to be seen. Regardless of philosophy, successful investing requires discipline, attention to detail and a lot of hard work.