2009-03-14

Understand What kind of stock investors you are?

One of the first things to understand about buying stocks is that what you buy is in some ways a function of who you are. If you're an optimist, growth investing might be for you. Long on patience? Value investing may be the better fit.

Individual investors generally fall into one of three categories: growth investors, value investors or dividend investors.

Growth
A stock's price often reflects how profitable investors think a company will be in the future. So most investors follow a growth strategy, which means that they look for companies with strong prospects for growing their sales and earnings. Definitions vary, but stocks expected to increase their sales (and their net income) from one year to the next by at least 15% generally qualify as growth stocks.

Value
Value investors follow a different path. They believe that the broader stock market always overreacts to news about a company. They seek out formerly hot stocks that have stumbled and whose share prices are at bargain levels.
Being cheap, though, isn't enough by itself. Value investors try to zero in on stocks that were beaten down due to temporary problems that can be fixed.

Dividends
Dividend investors buy stocks that pay a cash dividend based on the number of shares you own, usually on a quarterly basis. Unlike value and growth investors, who only make money when they sell, dividend investors get paid while they hold the stock.

Thus, dividend investors buy stocks as much for the income as they do for capital appreciation (which is what you get when you sell a stock at a higher price than you paid for it). Dividend investors look for financially solid companies with the wherewithal to continue paying their dividends, regardless of what's happening in the economy.

Putting a price on a stock
How do you know whether a stock is a value or priced for growth? Most investors rely on certain ratios that compare a stock's price to the underlying company's results.

The most commonly used valuation ratios are:

Price-to-earnings (P/E): This is a company's stock price divided by how much it earns per share over 12 months (expressed as earnings-per-share, or EPS). Most often, the EPS used is the most recent 12 months' earnings. Another way to calculate P/E is by using the consensus of Wall Street analysts' forecasts for a company's earnings in the current fiscal year. P/E is the most widely used valuation gauge.

Price-to-sales (P/S): A company's stock price divided by the most recent 12 months' sales-per-share. Some investors favor P/S over P/E because sales don’t vary as much as earnings from quarter to quarter. Another advantage is that you can calculate P/S, but not P/E, when a company loses money in a quarterly or annual reporting period.

Price-to-book (P/B): Also called book value, this is a company's assets minus its liabilities. A P/B ratio divides a company's stock price by its book value per share. Value investors tend to favor P/B.
There is no universal agreement on ratio values that define value or growth. Here’s my simplified take.


Defining value and growth
Ratio Value Growth Overpriced Growth
P/E Less than 15 More than 20 More than 50
P/S Less than 2.5 More than 3 More than 10
P/B Less than 3 More than 5 More than 15


Stocks with valuations in the gaps between the value and growth definitions -- say, a P/E of 18 and a P/B of 4 -- could be in either category, depending on the circumstances. Valuations in the Overpriced Growth column define stocks that many investors would consider overpriced.

But remember, your research doesn't end with these ratios. Figuring out whether a stock is worth buying is another task. A stock may be a value in terms of price, but its price may be depressed because something is seriously wrong. These ratios can help you understand whether a company's shares are cheap or expensive. If they are cheap, and you've done your work trying to find out why, then they may be attractive as a buy.

1 comment:

  1. Nice blogging, My review is very good example.
    Lindsay Rosenwald http://www.lindsayrosenwald.info/ Dr. Lindsay Rosenwald is one of the re-known venture capitalists and the hedge fund managers in the world

    ReplyDelete

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