Value investing is a speculative process based on the fundamentals of stock market trading. Closely tied with the theory of “buying and holding,” the speculation involves determining whether a stock is overpriced or undervalued by its performance. A simple understanding of a company’s financial statements allows a prospective investor to determine whether the company should be valued higher or lower than its current trading price. This analysis is closely tied to the stock’s price-to-earnings ratio, price-to-book value ratio, and its potential dividend yield.
A stock’s price-to-earnings ratio, or earnings multiple (notated P/E), is a measurement of its price relative to its profit. Its annual earnings per share is compared to its price in order to establish this analytical statistic. The lower a company’s earnings multiple, the more likely it is undervalued.
The price-to-book value ratio is often a valuable cross reference to the earnings ratio. Notated P/B, this ratio measures the price of a stock relative to its tangible assets. A low P/B is another clear indication of an undervalued stock. Combined with a low P/E, these ratios, when low, can be be trustworthy tools in determining the value of a position.
The dividend yield of a security is also a key indicator of its value. Having a regular dividend makes the position more attractive to potential investors, and at the same time, it shows a confidence in the growth and maintenance of positive earnings. A high dividend yield can make a stock valuable to own even if the market is not performing to its full potential. Holding onto such stocks through their rough patches will ultimately prove the stock to be undervalued by the market, and you will be paid for simply owning shares.
Determining whether or not a stock is undervalued by its price on the market is a key component to investing, and value investing is a fundamental knowledge that will serve any investor well in good or bad times. Magic Formula Investing is a simple form of value investing.
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