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Everyone should start investing in the stock market, and the earlier they do, the better. The sooner you make your money work for you, the sooner you will have a good retirement fund and the better off you'll be in the future. It's just that simple.
When you decide to invest, there's a lot you're going to need to learn. You will need to learn the most common stock market definitions, some basic stock trading strategies, and how to value stocks. Valuation is particularly important, especially if you want to invest like Warren Buffett.
Before you put down money in your stocks, take a look at how experts choose a stock's value using these simple steps below.
First, let's talk about what value is.
Everything can have value.
With some things, like vacation days, good friends, or even something as basic as human rights, the value is innate. You can't put a price tag on it; you just know it's good.
On the other hand, when we're talking about stocks, it's clear that there is a price tag that can be placed on it. This is called stock valuation, and it's the way that the market determines the price of a stock—and predicts where the stock is going.
You can't really come up with a tested way to value something like comedy or nights out. As you might guess from the numbers-oriented world of the stock market, there are legitimate, tried-and-true ways to learn how to value stocks.
There are really two types of stock valuation: intrinsic and extrinsic. The intrinsic value is the stock's value as far as its own worth goes, and it's found through heavy fundamental analyses. The stock's extrinsic value, on the other hand, involves applying valuation according to external factors—such as market hype.
So wait, why would anyone bother learning how to value stocks?
There are plenty of reasons why stock valuation is important. The most obvious reason is that it can tell you whether a stock's price is too high or too low.
Stocks are often misjudged when it comes to their intrinsic value. This is quite often because the stock market trading world tends to switch between being overly optimistic and overly pessimistic.
A company that has way too much hype will be overpriced, and when the market corrects, you may lose money. A company that's undervalued will have the price increase drastically over time—and is, therefore, a bargain.
Generally speaking, a company that's undervalued will also increase in price later on. So, to a point, you should learn how to value stocks to help predict the direction of your investments' growth.
Now that we understand the fundamentals, let's talk about how to value stocks.
Valuing a stock can be done by looking at a variety of different numerical readings—all of which can be found on typical investing apps. These include:
- P/E Ratio. This title stands for the Price to Earnings Ratio, and it's found through a variety of ways. The two most common are GAAP and adjusted valuation. GAAP stands for Generally Accepted Accounting Principles, while adjusted valuation means that certain other factors that may offer a more balanced view on the company's health.
- P/B Ratio. For people who are a bit more pessimistic about their investments, you can look at the Price-to-Book Ratio. This is a measure of how much a company would be worth if it was dissolved that day.
- PEG Ratio. The PEG Ratio, also known as Price to Earnings Growth Ratio, shows how fast the company grows and how the company would compare to most other stocks.
- Dividend Yield. When all else fails, knowing you'll have fixed income from your stock's dividends can help.
If you want to learn how to value a company the old fashioned way, look at the P/E Ratio.
The price of the share to the amount that the company earned with investors' money can say volumes about the company's health. Ideally, you will find companies that have a lower P/E ratio than others in their industry.
A low P/E ratio says good things for investors. This suggests that the price is not speculated, and that the company is using their money well. Here are some things to keep in mind:
- Different industries will have different P/E ratios. A typical clothing factory may only have a P/E ratio of around 8. Tech companies, on the other hand, may hover around 20 simply because it takes more money to make money in tech.
- A high P/E doesn't necessarily mean it's a bad buy. It could suggest that they are still developing the product.
- There's no perfect number for P/E ratios. Different investors look at different factors. Growth investors will look for different ratio numbers than value investors do.
- P/E ratios can only tell so much. There's a chance you could be seeing a value trap in the making. Use your common sense, and you'll find it guiding you well.
PEG ratios are better when you're figuring out how to value stocks' growth potential.
PEG ratios are ideal for people who want to value a stock and want to see where a stock's growth potential is headed. In terms of valuation, most people who use PEG ratios want to see where the company will go in the long term, and if the company is rapidly gaining traction.
The lower the PEG ratio, the better off you are. Any stock with a PEG ratio higher than 1 is typically seen as a bad buy, while those that have a valuation under 1 is a good buy. A solid one means that the price to earnings growth is totally proportional—and therefore matches market value.
A good rule of thumb would be to use PEG ratios in conjunction with P/E ratios when determining whether a stock is a winner. If both look healthy, you should be going in like Flynn.
Price-to-Books is for people who are worried about total economic collapse.
If you are very deeply concerned about the way things are going in the economy, the P/B ratio will help you figure out what's up. This number takes the current closing price of a stock share, and divides it by last quarter's "book price."
The book price is the worth of the entire company's assets, including property and patents. When you look at the P/B Ratio, you can get an idea of a company's extrinsic value is undervalued compared to their legit, intrinsic value.
In other words, it's a bargain spotter.
Of course, there's also Dividend Yield.
Most of the methods we covered that teach you how to value stocks are about long term investing and about the company's direct value. In some cases, you might be wondering what a company's stocks will do for you, especially if the value of the stock has plummeted.
Dividends are a good way to figure out a company's value for your portfolio. When you're looking at dividends, you're getting an idea of how much fixed income your stock pick will give you regardless of how bad the markets can be.
For people who want a safe bottom line, this is a good way to value stocks.
Though each metric tells you a little bit, there's really no magic formula.
You can go online and sign up for courses, and there will be a million different people telling you how to value stocks. Each of those people will have a little bit different advice, depending on their own investment strategies.
That's both the beautiful and aggravating thing about numbers; it's all about how you interpret them. The rules of thumb will typically guide you well, but it's up to you to make the final call.
That being said, there's a major issue that a lot of new investors do not fare well with...
No matter what the numbers say, you also have to worry about the potential of a value trap.
Value traps are something that can happen to anyone—even if you know how to value stocks like a pro. These "traps" happen when a stock ends up having numbers that look great on paper, but actually don't show the health of the company.
These traps will cause a loss for investors. Even veterans can get fooled by these traps, which is why they are so tough. These can happen for a variety of reasons including the following:
- Poor Bookkeeping. This is primarily an issue with penny stocks and may actually signal that a publicly traded company is a fraud.
- Cash Flow Problems. Many of the companies that had great P/E rations that "suddenly" folded were suffering from extreme cash flow issues.
- Peak Earnings. Some industries, like real estate, tend to boom and bust in cycles. If you look at the industry's earnings projections at its peak, you'd think that it's gonna be great. However, if the earnings are about to peak for that industry, you'll find yourself in a world of trouble.
Thankfully, signs do come up which show when you should worry—in most cases, at least.
The more you learn, the more you earn.
The cool thing about learning how to value stocks is that it's not just a one-day thing. You can spend months, or even years, learning better ways to do it. The more you learn, the better your buying decisions will be, and that will lead you to better profits.