I'm the first to admit that I'm not the world's greatest investor. I've confessed to many financial blunders here in Fooldom -- such as in this article where I urged readers to profit from my mistakes.
Still, I've learned enough to be able to impart some valuable lessons -- some, sadly, that I've learned the hard way. Permit me to share some thoughts with you today on how not to value stocks.
Don't look just at the price
A stock's price alone is much less meaningful than you may think. Sure, a $2 (or $0.25!) share price may seem cheap, but it isn't necessarily. Too often, people get excited by "low" prices, thinking that since their $1,000 can buy 4,000 shares of a $0.25 stock, they'll end up better off than they would be spending $1,000 on 10 shares of a $100 stock. But a $100 stock can be undervalued, and a $0.25 stock can fall even lower. Think of TheWashington Post
Don't look just at the 52-week high and low
Sometimes people will look at a stock's 52-week high and low prices. Doing so does give you a little bit of info. It helps you see whether the stock has recently fallen, and by how much, or whether it's trading anywhere near its most optimistic price in recent history. But it doesn't tell you whether it's a bargain.
Look at VerizonCommunications
Don't look just at the P/E ratio
It's hard to learn how to crunch a lot of numbers and come up with a detailed estimate of a company's true value. (Even if you do come up with a value, perhaps via a discounted cash flow analysis, you'll still inevitably be relying on estimates, which can ultimately prove incorrect.) Many investors, though, find it easy to just look at the P/E ratio. The P/E ratio can help you locate some companies that are carrying relatively low price tags, but it can also mislead you. Here are some reasons why:
- It's based on earnings per share. Earnings can be manipulated by companies, and per-share numbers can be affected when companies buy back or issue more shares and thereby reduce or increase, respectively, the number of shares outstanding.
- P/E ratios fall in different ranges for different industries. Car manufacturers, for example, sport low ones, while software firms tend to sport high ones.
- Some companies don't have earnings. If there's a loss, there's no P/E.
- Some companies may be terrific long-term investments, but if they had a bad year, their P/E ratio will not look so good.
- Other companies may be held in such high regard by investors that their high stock price has led to a high P/E. Such companies may be overvalued, but they also may simply be growing rapidly.
Don't look just at the dividend yield
Consider poor General Motors
Learn more about GM in these articles by Robert Allen and Mike Cianciolo. Philip Durell made a case for investing in Altria in another article of possible interest. Meanwhile, if it's dividends you're after, grab a free trial of our Motley Fool Income Investor newsletter, and you'll be able to peek at all the cash-generating investments we've recommended.
I'm running out of breath here, so let's move to the lightning round.
Don't look just at trends or stories. If a stock is touted because of the company's work toward curing cancer or fighting terrorism or providing inexpensive alternative energy, that's great, but stop short of investing until you see concrete results that you can bank on.
Don't look just at
market capitalization. It's useful since it shows you what price tag the market is placing on the whole company, but that price tag may be considerably higher or lower than it should be.
- Don't just listen to financial "experts." Experts are useful, though. They can point you to some promising investments. But do your own research as much as possible, and make your own decisions. Never follow anyone blindly, not even our own investing experts who offer monthly stock and mutual fund recommendations in our newsletters. (Our guys have impressive track records, though, so you might consider grabbing a free trial of one or more of our newsletters to see what we've recommended and our results so far.)
So what should you do?
Despite all the no-nos I listed above, there are some things you could or should do when valuing a company. For starters, you might consider doing many of the no-nos I listed above, instead of simply one or two. When you assemble a bunch of information on a company, you'll be able to draw more meaningful conclusions about it than you could with just one or a few data points. Seth Jayson recently offered some tools for lazy investors.
Remember that a price is simply what you pay for something. Value is what it's really worth. A stock may be priced at $50 per share, but its real value may be $75 (meaning it's currently undervalued and possibly a good buy for you) or $25 (meaning it's currently overvalued and may soon decline to a more realistic level once investors come to their senses).
Compare some numbers with other numbers. A stock's price alone is close to meaningless, but if you compare it with earnings, sales, free cash flow, or perhaps all of the above and then some, you have some results that are a lot more insightful.
Compare numbers you get with those of peers. If you see that Wal-Mart
If you're serious about wanting to learn how to read financial statements and evaluate companies, check out our well-regarded How-to Guides. They offer money-back guarantees, so you have little to lose and a lot to gain. We'll teach you a lot in an organized, easy-to-follow manner.
These following Fool articles can enlighten you even more on the topic of value and the evaluation of companies:
- Unlocking the Secrets of Value
- Profit From Pessimism
- Contrary to Popular Opinion
- The Bargain Hunter
- Beat the Street With Value
- Winning Ugly With Value
Selena Maranjian 's favorite discussion boards include Book Club, The Eclectic Library, and Card & Board Games. Sheowns shares of Microsoft, The Washington Post, and Wal-Mart. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.