Investors aiming to decide on what stocks to buy need to take a broad approach to investing. They should also look at three key metrics: p/e ratios, price-to-book-value ratios, and dividend yields.
When deciding on what stocks to buy, investors sometimes fall into a habit of focusing on those with a particularly attractive reading on a single investment measure. These readings can include a low price-to-earnings ratio, a low price-to-book-value ratio, or a high dividend yield. This can seem like a quick, easy way of spotting investment bargains.
However, most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
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Getting value from multiple investment measures while looking for what stocks to buy
To get value from any type of investment measure, you need to look at them in the context of everything else that’s going on, in the market and in individual stocks.
As mentioned, most types of investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
So, it’s a mistake to focus on stocks in the “suspiciously cheap” end of the p/e spectrum. It’s also a mistake to reject stocks of out hand, just because their high p/e’s and other clues make them seem too expensive.
Most of the time investors will find their best opportunities in the middle of the spectrum, far from the extremes of cheap to expensive.
3 investment measures to use together
There are three investment measures we suggest taking a close look at when buying stocks: price-to-earnings (P/E) ratio, price-to-book-value ratio and dividend yield.
p/e ratios: This is the ratio of a stock’s price to its per-share earnings. The standard p/e ratio involves using a stock’s current price and its earnings for the previous 12 months.
The general rule is that the lower a stock’s p/e ratio, the better. And a p/e of less than, say, 10, represents excellent value. A low p/e implies more profit for every dollar you invest. But you need more than one reliable measure to be a successful investor.
Like any ratio or investment rule, this one comes with many exceptions.
For example, in early 2000, some investors who focused on tech stocks were ready to disregard p/e’s altogether. Instead they zeroed in on statistics such as the number of “eyeballs” that websites attracted, transmission speeds of wireless Internet connections and so on. These days, investors have shifted back to more traditional measures like earnings and cash flow.
Some investors think the best way to pick undervalued stocks is to restrict their buying to stocks that are bargains in relation to measures like price/earnings. Some think they can even ignore investment quality and diversification if they choose low p/e stocks.
However, to profit from p/e’s, you need to put them in perspective. The p/e ratio is one of the first things you’ll look at when analyzing a stock. It shouldn’t be the only thing.
By themselves, p/e’s can steer you wrong on individual stocks, and on the market in general. There are lots of stocks out there that are cheap on a p/e basis. But many will remain cheap—their share prices won’t be rising any time soon.
Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This ratio captures a “snapshot” of an instant in time, and could change the next day.
When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, which means they may be in danger of being written down.
Dividend yield: If you’re looking for what stocks to buy, you will want to consider stocks paying a dividend yield.
Stocks with high dividend yield are a key part of a successful portfolio—but at the same time, they can give investors a false sense of security.
When looking for stocks with high dividend yields, you should avoid the temptation to seek out stocks with the highest yields—simply because they have above-average yields. That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend.
Above all, for a true measure of stability in what stocks to buy, focus on stocks that have a high dividend yield that has been maintained or raised during economic or stock-market downturns. Generally, these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.
What is your favourite indicator for stocks? Do you use it all the time?
What prompted you to buy the most successful stock you’ve ever owned?
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