Here Are The Best Ways to Value a Stock
Before you decide purchasing some fractional ownership stakes to a certain company, it is important to understand first how it works. For starters, the stock’s intrinsic value does not necessarily get tied to its current market price. And when talking about value investing, the great Warren Buffet said that determining a stock’s true worth is quite significant. Hence, the discipline to value a stock can be considered an art. While there is a plethora of methods out there, they all speak of the same idea. That is, calculations done with a small amount of humility are often more realistic.
#1. Keep Calm and Use Numbers Wisely
It is true that a good investor does not stop from fantasizing when it comes to selling off shares for more than their worth. If your stocks hit a high number, you sell. But what if it is the other way around? You might think about not selling obviously. Well, actually, it is wrong. Even if your stocks deeply plummet to your lower number, you would still want to sell. For example, if the price rises to $40 per share or drops to $32 at close of trading day, it would still trigger a sale.
#2. The P/E Ratio
This is without a doubt the go-to metric if you really want to value a stock. It simply means price-to-earnings, which is a formula calculated by dividing the stock price by the EPS or earnings per share. Meaning, the lower the P/E ratio is the more earnings investors are purchasing in each share.
#3. Understanding GAAP
GAAP or Generally Accepted Account Principles is a standard to which any company must comply. This can be applied to earnings per share, allowing you to find a multiple going forward that pretty much hits 16.5. Most experts use the latter, as it is considered the 40-year average for equities. And by using it, you can be sure that you are not overpaying for a company’s earnings.
#4. Value a Stock But Don’t Get Trapped
A stock becomes a value trap if it appears to be cheap. However, when you look closely, it is not due to a deteriorating business. An epitome is a pharmaceutical company having a valuable patent that is set to expire. And if you are not careful, you would not notice it is a pitfall. At first, you would think that the shares are a steal. Hence, you will be convinced to give in. This would often lead you to losing a golden opportunity to take advantage on various discounts to stocks you could have invested on. This is definitely not the kind of strategy you want on how to value a stock.
#5. Brand name/Economic Moat
Coined by Warrant Buffer, economic moat is a phrase refers to a company’s ability to steadily have a competitive advantage over its peers. Not only is it an important thing, it is also a very powerful element. That is because it effectively keeps other businesses from getting into the sector. More importantly, it makes the stock worth more over time. A strong brand name is among the best examples when considering an economic moat. Although this is not the kind that you can nail down using a specific dollar, it is still capable of swaying you in the direction towards the worthiness of an investment in the stock.