You can see choosing stocks like buying a car or a cellphone. Let’s take cellphones. Before you buy a cellphone you have to decide what kind of cellphone you want. So you might want a cellphone that has a big screen, a good camera and a lot of memory. Once you have decided what you want, you have to find the companies that offer that kind of cellphone. Finally, you will pick the one that has the best quality-price ratio.
There are different methods for choosing stocks, but the one I will be talking about today is the valuation based on comparable. Essentially, you compare different enterprises (cellphones) that are somewhat similar to see if their value match (quality-price), if it doesn’t you buy the stock of the one that is selling at discount.
To do that, you compare their ratios. It will tell you if the stock is relatively fairly valued, relatively undervalued, or relatively overvalued. So we imply that the investment we value should have equal ratios as the comparable company (Similar cellphones should have similar prices).
Selecting stocks with ratios:
- Price/Earnings (P/E)
- Price/Book (P/B) (Book meaning that it comes from accounting records)
- Price/Sales
Let’s start by taking a look at the P/E ratio. One thing to have in mind about this ratio is that there are two variation of it.
- Trailing P/E: Which is the current market price divided by the most recent EPS reported
- Forward P/E: Which is the current market price divided by the prospective/expected EPS of next year
In this blog post I won’t go over the Forward P/E because it would take a whole blog post on its own.
P/E
| Company | P/E |
| A | 12 |
| B | 8 |
In the example above, we can see that the stock of company A is more expensive than company B. You are paying 12 times for 1$ of profit the company makes.
P/B
In the case of P/B, you can get it by taking shareholders’ equity and dividing it by the number of common stocks outstanding. This ratio can be particularly interesting for finance, investment, insurance, and banking institutions. Let take an example:
| Company | P/B Ratio |
| A | 10 |
| Industry | 5 |
Here we can say that Company A appears to be overvalued compared to the industry.
P/S
Taking P/S, you get the denominator by dividing net sales by the number of common stocks outstanding.
| Company | P/S |
| A | 4 |
| B | 2 |
Here, we can say that company B seems to be undervalued compared to company A.
Before finishing do not forget that finance professionals who pick stocks to include in their portfolio have a CFA degree. Meaning that they are really knowledgeable and that picking stocks is not easy, far from it. However, taking what you learned here to choose your stocks is way better than following your gut feeling. So mainly my objective for this blog post was to take you to do some research before choosing your stocks and make emphasize that, as this blog post may seem, it is not easy to pick stocks.
Please, do not believe that only following the guideline on this post will assure you that you have selected the right stocks! It’s just a bare start for analysing.