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How to create a stock valuation

Fundamental SWOT analysis and number crunching are used to eliminate high risk or unattractive stocks. It should ultimately help the investor to weed out an exciting growth company with strong underlying attractions, limited risks and weaknesses, an exceptional management team and most importantly, lots of potentials.

stock valuation

But there is one other important factor to think about before buying a stock.

The Valuation

As the famous economist, Richard Thaler once said:

“Investors must keep in mind that there’s a difference between a good company and a good stock. After all, you can buy a good car but pay too much for it.”

So how are shares valued?

The price of a share is dependent on a number of factors, including the size (blue chips have less growth potential – as the fund manager Jim Slater always said, “Elephants don’t gallop”), the sector (reliable markets command higher ratings), the debt (a high level of debt is undesirable) and profitability.

PE Ratios

Profitability is reflected in the Price to Earnings Ratio (PE Ratio) which is commonly used by market analysts.

PE Ratio = Share Price / Earnings Per Share

Analysts might talk about a stock trading at a multiple of 12 times earnings; meaning the PE Ratio is 12.

In reference to small-cap or growth stocks, a low PE Ratio (less than 10) suggests that there is risk associated with the investment, or that it has a limited track record. This is where stocks can be bought up cheaply; some will do well and soar in value, while others will disappoint and dive.

At this early stage, young company stocks can be a gamble. That is why it’s crucial to do thorough research and pick a stock that inspires real faith.

Mid-cap and blue-chip companies usually command high PE Ratios (more than 16) based on the current year’s earning potential. These stocks are not necessarily overvalued, but their reliable and steady growth prospects are priced into the stock.

Dividend Yields

As a reward, established stocks usually pay dividends to their shareholders, which creates a small bonus income.

Dividend Yield = Dividend Per Share / Share Price x 100

This compares to current bank savings rates. Investing money with a bank for one year might generate 5-6% interest, risk-free. But an 8% yield with a blue chip stock may be worthwhile since this is probably the least risky type of stock market investment.

Holding Stocks

stock

However, for many people, capital growth is the main reason to invest. That is the appreciation of a stock over several months or years.

When buying a stock, aim to hold it for a minimum of six months, ideally 1-3 years, and sometimes even longer. A solid growth business that keeps on expanding and delivering greater profits every year will deliver good ongoing returns for its shareholders.

Finally, there are many triggers for selling stock but it is wise to monitor the valuation. If the market is too fond of a share, the price may become over-inflated and that is rarely sustained for long.

How to Buy Stocks

Due to the sub-prime credit crisis, the US stock markets haven fallen by more than 40% year-on-year. But eventually, they will bottom-out, and when that happens, it will pay to know how to buy stocks to make money from the best value investments on the market.

As a beginner investor, it’s crucial not to buy stocks before learning the basics. The following is an easy guide to trading stocks – including how to open a stock trading account, how to do stock research and other useful trading tips.

How to Open a Stock Trading Account

Investors need a stockbroker to invest in the stock market. The broker will open a stock trading account and trade stocks on the client’s behalf. There are two types of stockbroker:

Full-Service Stock Brokers – offer a variety of financial products, as well as specific investment advice and stock research. But this hand-holding comes at a price, and each trade usually costs more in commission.
Discount Stock Brokers – only execute trading instructions; they do not advise on the stocks being traded. Discount stock brokers usually offer an online stock trading account, and only charge a few dollars per trade, no matter how big or small.

There are many stockbrokers offering their services online; a quick search on Google will reveal the leading names and their typical trading charges. Many offer the option of setting up a stock trading account online, which can then be funded with money from a bank account.

How to do Stock Research

How to create a stock valuation

Stock picking is all about research. There are two ways to do stock research:

Fundamental Analysis – considers the underlying business performance, such as revenues, profits, dividends, growth potential, risks, competitive advantages, etc.
Technical Analysis – considers the historical performance of the stock in terms of price, demand, volatility, etc.

There are strong arguments for both types of stock research. Beginner investors should probably being with fundamental analysis, focusing on industries they are already familiar with and can judge the market potential and risks. Technical analysis often works as a good back-up measure, checking the facts against how the market currently values the stock.

Other methods of stock selection include:

Stock tip sheets
Investment publications
Broker research notes

Useful Stock Trading Tips

Brokers – beware of stockbrokers who call up out of the blue and offer a stock that is “guaranteed to skyrocket any time now”. These brokers work on commission and only care about getting people to make trades so they can skim a profit.
Volatility – smaller stocks are often more volatile than blue chip stocks. This means they are inherently riskier and should be approached with more caution. While they offer huge potential returns due to the discounted nature of young stock, they also run the risk of folding at short notice.
Long term investing – for many investors, stock trading is a long term game. It is unusual to profit from single stocks in a matter of days without some insider knowledge or market manipulation. Often, investors buy stocks and allow them time to increase in value, maybe over several months or years.
When to sell – stocks can be sold when the valuation (annual profits in relation to the stock price) becomes too high. Stock tip sheets, investor publications, and broker research note often publish new stock valuations after some major news or financial accounts go public.