Here are some tips that we think will show you how to make investments that will pay off with better long-term returns

Investing success comes with knowing how to make investments more wisely, which involves more right decisions than wrong ones over a long period of time.

Here are some valuation tools and investment strategies that will help you make better decisions—and as a result, give you better returns over the course of your investing career.

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How to make investments: Key valuation tools

Many investment-valuation tools provide a reading on a scale or spectrum between two extremes. The most-appealing stocks are usually in the middle of the scale. For example, risk is highest at the two extreme ends of the scale.

Consider the P/E ratio—the ratio of a stock’s price to its per-share earnings. Many investors instinctively understand that a high P/E can be a danger sign, because it suggests a stock may be overpriced. But you also need to be wary of stocks with low P/Es.

A low P/E ratio appeals to a lot of investors, because it seems to signal a bargain. Often, however, an unusually low P/E signals hidden danger. It means investors doubt the quality or sustainability of the “E”’—the company’s earnings. So, in their collective wisdom, investors cut the multiple they are willing to pay for those earnings, relative to stocks that are otherwise comparable, or to the market as a whole.

These doubts may reflect fears that a company’s business is headed for a slump. Or, investors may fear an industry-wide downturn.

How to make investments: Stock valuation using price-to-sales ratios

You get the price-to-sales ratio when you divide a stock’s price by its sales per share (you arrive at sales per share by dividing total annual sales by the number of outstanding shares).

Sales is the raw material of earnings; that is, sales minus expenses equals earnings, so earnings are always less than sales.

The ratio will give you some idea of how healthy a company is. Likewise, the price-sales ratio can also give you some insight into how you may be able to benefit from a particular stock.

The basic rule is that a lower price-to-sales ratio means that a stock is cheap. A higher p/s tends to indicate that a stock is expensive. Still, many individual stocks can run counter to this rule. Stocks with deservedly high p/s ratios can rise for lengthy periods, while stocks with deservedly low p/s ratios can fall.

That’s why it’s important to keep price-to-sales ratios in perspective. They tend to provide hints rather than clear answers. And they are only one among many tools in stock research.

How to make investments: Diversify for long-term gains

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices rise, but in that case, your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which pushes up the value of your Utilities stocks.

As part of their portfolio diversification strategy, most investors should have investments in most, if not all, of these five sectors. The proper proportions for you depend on your temperament and circumstances.

How to make investments: Here are more key tips

As part of our Successful Investor philosophy, we feel stocks that have been paying dividends for over 10 years are some of the safest investments you can make. Dividends are a sign of quality and a company’s financial health. Types of dividend-paying stocks that we consider to be safer investments include Canadian banks and utilities.

There are also a host of other key indicators to determine if a stock is a safer investment, like the company’s management integrity, its growth prospects and its stock price in relation to its sales, earnings, cash flow and so on.

For a true measure of stability, focus on those companies that have maintained or raised their dividends during an economic or stock-market downturn. So all in all, we think investors will profit most—and with the least risk—by buying shares of well-established, dividend-paying stocks with strong growth prospects.

Do you focus on market predictions when deciding on investments to make, or do you pay more attention to historical data related to the stock?

Do you have a favourite tool for choosing stocks? If so, why do you prefer it over other options?