If you are wondering how to determine a stock’s value, make sure you aren’t misled by investing formula strategies or an over-reliance on financial ratios or other value indicators
When they first set out to find stocks to buy, many investors decide to base their investment decisions on a handful of measures. However, the best investment plans or systems use a variation of our value investing approach. That is, they revolve around choosing high-quality investments and diversifying their holdings. Our three-pronged value investing program takes that general description a little further.
Meanwhile, when you’re deciding how to determine a stock’s value, you could include measures such as financial ratios—but don’t over-rely on these indicators.
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What you need to know about investment indicators/formulas and how to determine a stock’s value
Most formulas start with a seemingly reasonable proposition about bargains in the stock market. The formula may depend on value factors such as a low stock price, a low P/E ratio, a high dividend yield, or a low ratio of stock price to book value. Or it may be based on foreign-exchange rates, long- and short-term interest rates, or price-change statistics.
Investing formulas all come down to something like this: If you make a particular trade or trades on a regular schedule, based on these fixed criteria, and stick with the formula and schedule for a number of years, you’ll earn above-average profits with relatively low risk.
The support for these claims comes from “back-testing.” That is, formula promoters check historical records to see how the formula would have worked in the past. Often they tinker with the formula and back-test different versions of it, over a variety of historical periods, and only tell investors about the results of the tests that generated a profit.
Investment professionals sometimes refer to this formula-creation process as, “first-you-shoot-the-arrow, then-you-draw-the-target-around-it.”
The problem is that the formula can only work in the future if there’s some consistency in the relationship between the elements in the formula and the outcomes of the trades. You can spot that consistency when you study the past, but it may be due to a unique series of coincidences. You can’t predict how long (or if) anything similar will appear in the future.
Our readers and clients sometimes come across an intriguing formula that seems to have worked in the past, and ask if it’s worth a try. We advise against it. We can’t see how it can add any value. After all, it’s akin to a bet on a randomly generated number.
An additional negative is that formula-investing fans only expect their formula to pay off for you “on average,” if you apply it consistently over a period of years. However, committing to a series of financial decisions for years ahead is always a risky procedure.
If you commit to a formula-investing schedule just when the chain of coincidences dries up, you could be in for years of financial and psychological pain.
How to determine a stock’s value: Four ratios we look at as part of our stock selection process
Debt-to-equity: When a company loses money, it still has to pay the interest and eventually repay the debt. Generally it does so by dipping into shareholders’ equity. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump.
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.
Price-cash flow ratios: Simply put, this is earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. It can actually be a better measure of a company’s performance than earnings.
Price-earnings ratios (or p/e ratio): The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents value.
How to determine a stock’s value with our Successful Investor philosophy
Psychologists tell us that people instinctively look for patterns in their environment, such as, “When the animals in the jungle go quiet at night, a predator may be coming to eat us,” or, “When it gets cold, we can stay alive if we walk in the direction that the birds are flying.”
This kind of pattern detection helped our ancestors make sense of the physical world and avoid its dangers. It helped us survive through prehistory. But in the modern world, when we pursue intangibles such as investment success, it’s all too easy to detect patterns that exist only in our imaginations.
Many of the factors that investment formulas rely on do carry important bits of information, of course. They can help your investing, but only if you put them in perspective. When you use them in a fixed investing formula, they can do more harm than good.
It makes far more sense to disregard formulas. Instead, practice our TSI approach to investment success: focus on investment quality and diversification, and stay out of the faddish and fashionable stocks you’ll find in the broker/media limelight. This won’t give you a sure profit or a peephole into the future, but those are impossible goals. You’re better off to focus on the achievable goal of succeeding as an investor.
What value points do you look for the most when considering stocks?
Do you ever use formulas by themselves to make decisions on stock purchases? How has that worked out?
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My formula for success is not in any formula, it’s using Pat’s recommendations backed by many years of experience and an excellent research team. I have been a subscriber to some and now all of his newsletters included in the Inner Circle membership and have more than doubled my portfolio over the last 10 1/2 years. What more can you ask for, growth and reasonable security. After all this is the stock market.