Many investors jump to the conclusion that investment research is useless and that “beating the market” in the long run is not possible. But the long run is precisely when research may achieve its greatest usefulness. It is in the short run that logical evaluation is subject to the foibles of the human mind. For example, analysis can lead one to see patterns where none exist. Our primitive brains are apparently wired to act on impulse by the evaluation of past information – even random data. Investors who rely too much on past information become overly optimistic about stock market winners and overly pessimistic about stock market losers. Stock price patters do not persist – over the long term.This simply means that analysis of past information requires us to examine the long term to make sure that short-term results are validated. Decisions need to be the result of calm analysis of fundamental value.
Investing involves some rigorous work – just like maintaining your home. But investing should not be a constant struggle to follow a lot of rules. Rather, it should be like shopping for bargains at any store…or online. Buying a stock means that you are going to own part of a company. It’s that simple. Don’t become confused about asset allocation, rebalancing, industry trends, and market sentiment. Just focus on buying companies with promising opportunities for rising profit. What you will actually own is your part of those future profits.
Focus on a company’s prospect for future profits, not periodic fluctuations in the stock price. You are investing, not speculating. Spotting a bargain price for the company you are buying is often more art than science. But you can learn this process. You likely already know the most common measure of value. That is, the measurement of how much you are paying for future profits. You pay a price in dollars for each share of stock in the company. Profits are also stated in dollars per share. Hence, the ratio of price per share to earnings per share (the P/E) is a simple measure of value. It’s not the only way to measure value, but it’s always a good start.
The higher the P/E ratio, the more you are paying for your part of the profit. So, a stock with a big P/E is more “expensive”. That doesn’t mean the stock in a company with a low P/E is necessarily a bargain relative to a stock with a higher P/E. After all, you will own a share of future profits, which are unknown guesses. Maybe future profits for a company with a high P/E will rise more than the future profits for a company with a low P/E. In that case, the stock with a high current P/E may be worth owning because the “E” – the earnings – will increase significantly. Similarly, a low P/E stock may have a low “P” – the price – as a reflection of the fact that “E” (earnings) are expected to decrease in the future. But as a general rule, stock in a company with a really high P/E should be avoided; stock in a company with a fairly low P/E is worth considering.
Ready to be a little more sophisticated? Take the current P/E ratio – using the present price and the present earnings. Now compare this to the company’s average P/E over the last 10 years or even 20 years. That’s a reasonably long term. If a company’s current P/E is lower than the average, it may be a bargain. That is, the price for the particular company is currently lower relative to earnings than has historically been the case. It’s like the company is on sale because the cost to own a piece of the company’s earnings is lower.
Now you’re on you way to learning some simple techniques for examining individual stocks. Try learning a new analytical method every few months.