Each of the best investors have a slightly different strategy for beating the Street. Every investor needs to know about how to value a company. If you don’t know how to value a company, then there is a small chance you will succeed in the long run.
There’s multiple ways that investors value companies though:
- Based on Book Value
- Based on P/E ratios and earnings growth (defined below)
- Based on Future Cash Flows
- Based on being a boss and just winging that mental math
This is the method that Benjamin Graham used and became famous for. His style of investing was named “Value Investing.” It revolves around the idea that companies can be valued at a discount to what they’re actually worth. It is much the same way that if you were to find a Gucci article of clothing for 50% you would buy it. Gucci is a good brand of clothes and it’s made a lot cheaper! However, humans don’t like doing this. We like “investing” in things that are only going up or companies that just went up a lot. This is the “fear of missing out” syndrome. To be a great investor, you need to ignore this and be able to laugh at all the people investing in over priced companies.
Now, Book Value as defined in Level Jan, is the amount of assets that a company owns. Graham would look for companies that had a lot of assets compared to the price. You can do this easily by looking up a company’s Price to Book Value. This will give you the value of the company divided by the book value. Each industry is unique on what is a good value, so do some looking around and compare as necessary. If you go to http://www.morningstar.com , click on a company, and then click on Valuation it’ll give you a lot of these multiples. BOOM knowledge.
PE and PEG
Remember that old PE ratio that we talked about a character or two ago? Well some of the best investors use this to know when to buy a stock. Now, a company’s PE ratio essentially tells you the price of a stock divided by the amount of earnings for that stock. So, you want a company that is earnings more and more money per share each year. That way the share becomes more valuable. However, companies grow their earnings per share at different rates.
Example time chumps: Your company, Bad Haircuts Before Picture Day, had earnings per share of $1 this last year. The price of each share is $15. If you need a brush up on what this means, review here. Say next year you’ve suckers tons more kids into a terrible haircut though and you grow your earnings to $1.20 per share. This means your earnings grew 20%. Now, your PE was 15 initially. The formula for is:
PEG = PE / Earnings Growth.
The PEG in this example would be 15/20 = .75. Now, why am I telling you this? Because, the greatest investors wait until the companies they want to buy have a lower PE, meaning that their earnings growth is pretty high compared to the price they’re paying. This is a solid way to make sure to get a bang for your buck. We will eventually go over what values are better for this metric, but in general below 1.25 is acceptable.