Selecting Stocks for Investment
“Buy low, sell high!” This is the simple goal of every rational investor in the stock market irrespective of their reason for investing in the first place or the time frame. It is therefore very important to know how to identify and take advantage of mis-pricings in the stock market in order to achieve this goal. In a nutshell, an investor must be able to identify stocks that are cheap in the stock market and have the potential to rise over a period of time based on good business fundamentals.
An easy and quick way of determining whether stocks are cheap or expensive is through the use of price multiples. Two commonly used price multiples are the price-to-earnings ratio and the price-to-book value ratio. While the former tells you how much you are paying for a company’s future earnings (profits), the latter tells you how much you are paying for the residual assets of a company should it go bust. However, both multiples are most useful on a relative basis, that is, for making comparisons between the stocks of two or more companies operating in the same industry and that have similar business fundamentals.
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