You’re about to read an article about how to choose stocks to buy. If you’d rather not choose your own stocks, but still think you should have them in your portfolio, consider using an “institutional money manager.” Learn how the big players have their portfolios managed in the video called, “What is a Separately Managed Account – and Should I have one?”
Many people check stock prices, and base their buy/sell decisions on the quotes. However, there is a fundamental difference between a stock’s price and value. Decisions to buy/sell should take into consideration a stock’s value.
A stock’s value is determined by the size of the company’s dividend, net worth, prospects for future earnings, and other factors. A stock’s price, however, is more subjective because price is affected simply by the supply and demand of the market at any given time. The market is full of stocks with significant lack of correspondence between price and value. These differences may be “explained” by ratios, and you need to make sense of the disparities to determine whether a stock would be a wise investment.
Rather than asking what a stock is worth, learn what a company is worth in relation to its share price. One of the most common tools people use helps them to see if the price they are paying for a share of stock is reasonable given the amount of earnings the company makes. That tool is a number called the “Price-Earnings Ratio.”
P/E Ratio
The price-to-earning ratio (P/E) is the price per share divided by a company’s annual earnings per share, and it is a fairly objective way of comparing one company to another in the same field. Some “hot” stocks have over-inflated P/Es because shareholders are willing to pay high prices for what they consider a “must have.” They overlook solid companies in other less fashionable areas, which might have low P/E ratios. Diligent investors might even find some selling for less than “book value” (the per-share value of the company’s net worth). However, don’t rush to buy a stock with a low P/E. First, investigate why it is low. Is it due to the management’s creative cost cutting, or does it reflect major internal problems?
What’s it Worth to You?
After determining a stock has good value, don’t buy before considering if it has a place in your portfolio. Every asset you buy should fit into your asset allocation and risk tolerance models. Then you can judge its value and decide to sell or hold on when there are fluctuations in share price. Knowing the value and the price of your stocks is key to investing successfully.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published August 10, 2014. Updated June 2021