Question: How do I know if the price of a stock is already good for buying or selling? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram, and Facebook
Answer: By your question, it seems you are in the stock market more for capital appreciation than for current income (i.e. earning cash dividends).
You have probably heard the adage of buy low and sell high. But how low is low and how high is high? The answer lies in the valuation of the company that the traded stock represents.
Think of it this way, when you first set out in your career, you had nothing but your equity. That equity was represented by your stock of knowledge, training and experience (if any) plus whatever monetary assets you had at that time. At the start, your equity was equal to your assets (i.e. the value of your monetary assets plus the present value of the earning potential of your stock of knowledge, training and experience).
You deployed your assets either by getting a job or going into business for yourself. You started to earn income. But being young and restless, you just consumed what income you earned, leaving nothing for savings.
It is said that man is never satisfied. And you yourself wanted to improve your lifestyle perhaps through travel, buying a car, renting a place for yourself and maybe even starting your own family. All the time, you also wanted your capacity to spend to cope with inflation.
The way you could afford the better lifestyle and keep pace with inflation was to acquire more assets to generate more income. And to buy more assets, you either borrowed or saved. What was essential was that the assets you bought generated more revenues from which you had enough left over in cash savings to afford that better lifestyle (i.e. cash dividends to yourself) while repaying your debt and reinvesting in more earning assets.
In short, growth in earnings is the key. The same is true for companies listed on a stock exchange. That growth in earnings is captured in company valuations.
To standardize valuations, analysts use financial ratios. To be sure, there is no one ratio that can capture the valuation of a company completely. Nonetheless, some of the more commonly ratios used are price-to-earnings (P/E) multiple, P/E to growth or PEG, price to book, return on equity and discounted cash flow.
But it is not as simple as dividing one number by another. Ratios can be based on historical as well as forecasted numbers.
While there can only be one set of historical numbers, past performance is not a guarantee of future return. On the other hand, forecasts can be as numerous and varied as the number of forecasters. Ratios may also be compared to the historical performance of a company or to others. In this case, it is important that comparisons are made only to other companies in the same sector. There is also the matter of making adjustments to account for differences in accounting policies.
In the end, the valuation per share is compared to the prevailing stock price to see if a company is a good buy or a goodbye.
Some say the best valuation of a company is its stock price because that price is based on the collective wisdom of investors and traders in the market. Just make sure that the period from which you are extracting that price is one that is not characterized by excessively bullishness or bearishness. Otherwise, the valuation may be based on the collective foolishness of the market. INQ