My name is Anders Bøgebeck. My mission is to help you become a better investor and trader. Why is this important? We are not only helping ourselves by becoming financially free. Along the way we help society by either allocating capital the right places or creating better products and services. That's why I want to help you achieve the life you desire!
I'm writing this blog post to highlight some of the different ways valutation can be used to time an entry in a stock position. Many people only look at the PE ratio (Price / Earnings ratio) as the only way to measure valutation. I will show some of the different tools to use depending on the type of company, we are looking at.
We need to divide our valuation analysis and our approach based on whether we are looking at an established company or high growth company. Let's look at each of them.
First of all, these high growth companies are extremely hard to value, because their future is so uncertain. Many high growth companies invest aggresively in their own business, take on a lot of debt and sell their own shares to provide capital. If you are working on such a good business idea, that your products can beat the market, you should definitely be aggresive. Therefore, the traditional PE ratio does not really work, because most of these companies do not have any profit yet.
Looking at expected growth
The most obvious metric for a growth company is to look at growing sales. Growing sales is a measure of popularity of the products. Therefore, the price/sales ratio is ideal. You would expect, that the "fair" ratio would be close to the expected sales growth. Once again, no one knows the exact sales growth for the future, but this can serve as a good indication.
Established companies are a lot easier to valuate, because it's easier to count on estimated earnings growth. When looking at "fair" PE ratio, we must take into account three elements:
If you have an established company with 45% earnings growth each year in a low interest rate environment, it is possible to see PE ratios of 150 or more. Those are the "fair" values"! The PE ratio will get even more crazy, if its a low beta stock. But beware; if the risk-free interest rate is extremely low, then PE ratios can easily plunge. When the interest rate go up again, capital will leave the stock market and enter the bond market.
Historical PE ratios
Some companies will have PE ratios that are chronically above "fair". For some reason the market is willing to pay a premium. Does that mean, that we should never enter the stock, if it is a fantastic company? No, we should instead compare the historical PE ratios of the company and check out what is low. Check out this article from seekingalpha.com, which explains this phenomenon: https://seekingalpha.com/article/4312007-right-way-to-value-growth-stocks-part-3
When entering a great fundamental stock, it is a good idea to check out the current valuation. This can provide and great insight to whether you're making a good deal. However, don't expect to time the market perfectly! Remember, that if you are entering a great company, then the theoretical "fair" market value of that company should increase year by year. That is your edge in investing! Good luck.
|How to build the best stock portfolio with Portfoliovisualizer||Why fundamental analysis is not working in the stock market||The different type of risks a stock-trader faces|