Using value investing key metrics like P/E and price-to-book ratios will help you identify quantify stocks, but you need a broader approach to profit. Learn more here
To succeed as an investor, you have to take a broad view to make investment decisions. Technical analysis and other narrow views do sometimes seem to “work” for lengthy periods, of course. But they only work for a minority of the time, and they never work consistently. Instead, they run hot and cold. As with all random events, their successes occur in bunches.
Value investors zero in on value investing key metrics as an indicator of what to buy. They like to buy stocks with low ratios of stock price to per-share earnings, cash flow, sales and book value. They assume that if you get enough value in your stock buys, indicated by low numbers in these ratios, your profit is virtually assured, in the long run if not in the short.
Of course, there are no guarantees. In fact, a low p/e and other low readings in value-investor ratios may simply mean that well-informed investors are selling the stock and pushing down the “p” or stock price. If so, it probably means they see flaws in the company’s situation or outlook that investors are generally missing. Even so, ratios are a good starting point.
Here are three value investing metrics for successful investors
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 we put at the top of our list for wealth management clients: p/e ratios, price-to-book-value ratios, and dividend yields.
P/E ratios are one of the value investing key metrics you should look at
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, typically represents excellent value. A low p/e implies more profit for every dollar you invest.
But like any ratio or investment rule, this one comes with many exceptions.
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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 are another one of the value investing key metrics investors need to pay attention to
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.
When looking at value investing key metrics, don’t forget dividend yield
In short, it’s risky to buy a stock solely because it’s a high dividend stock. That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend-paying stock’s yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut.
While high-dividend stocks may be perfect for your portfolio, here are some other factors to look at when evaluating a stock’s dividend sustainability:
5-to-10-year history of profit.
5 to 10 years of dividends.
Industry prominence if not dominance.
Freedom from business cycles.
Ownership of strong brand names and an impeccable reputation.
Use our three-part Successful Investor approach as part of your value investing strategy
Hold mostly high-quality, dividend-paying stocks.
Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
Downplay or stay out of stocks in the broker/media limelight.
What key metric have your relied on in the past to evaluate stock picks?
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