What does all this have to do with picking solid stocks? By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return. No one knows what a stocks speculative return will be over the next year – or even 10 years- but we can make pretty educated guesses about the investment returns. If you find great companies, value them carefully, and purchase them only at a discount to a reasonable valuation estimate, you’ll be fairly well insulated against the vicissitudes of market emotion.
Careful attention to valuation lessens the risk that something truly unknown- what other investors will pay for our asset in future –will hurt the return of our portfolio. As investors, we can diligently work to identify wonderful businesses, but we can’t predict how other market participants will value stocks, so we shouldn’t try.
Being picky about valuation isn’t fun. It means letting many pitches go by and watching many stocks run –stocks that never met your strict valuation criteria. But when its done properly, disciplined valuation also greatly increases your batting average – the number of stocks you pick that do well versus the number that do poorly – and it also limits the odds of a real blow-up damaging your portfolio.
Using Price multiples wisely
Our first stop in learning how to value stocks is traditional measures such as the price-to-sales (P/S) or price-to-earnings P/E ratios. Although these measures do have some advantages – for example, they are very easy to compute and use – they also have some significant pitfalls that can lead the unwary investor to fuzzy conclusions.
Graham Number is calculated as follows: Graham Number = Square Root of (22.5 * Book Value * Earnings per share) = Square Root of (22.5 * Net Income * Shareholder’s Equity) / Shares Outstanding- He wrote in “The Intelligent Investor” (1948 version) regarding to the criteria for purchases:- “Current price should not be more than […]
It is, of course, irritating that extra care in thinking is not all good but actually introduces extra error. But most good things have undesired “side effects,” and thinking is no exception. The best defense is that of the best physicists, who systematically criticize themselves to an extreme degree, using a mindset described by Nobel […]
If you don’t know enough to know about the business instantly, you won’t know enough in a month or in two months. You have to have sort of the background of understanding and knowing what you do or don’t understand. That is the key. It is defining your circle of competence. Everybody has got a different […]