How to Estimate Companies' Price and Make Investment Decisions
The price of a company often influences your decision whether to invest in it or not. Of course, you can neglect this property and use, say, tech analysis; however, knowing the real market price of a chosen company, an experienced investor can make conclusions about the results of their investments in the long run.
In this article, I will not focus on evaluating and analyzing companies for speculative or short-term trading. My goal is to teach you to determine the price of the company and your perspectives of long-term investments. By long-term, I mean several years or even decades. This is how known-to-all Warren Buffett invests.
Underestimated companies will always be more profitable in terms of investments because their stock price is likely to grow in the future. As for overestimated companies, their perspectives are more modest or lacking at all. The stocks of such companies might soon correct, which will lead to unreasonable losses or freeze your investments.
Estimating the cost of a company
For a complex estimation of a company's price, several multipliers can be used:
P/E (Price to Earnings) is a multiplier showing the under- or overestimated state of companies. Using the P/E multiplier, an investor can forecast when their money will pay back. The smaller P/E, the sooner it will happen. We already discussed P/E in earlier articles.
P/S (Price to Sales ratio) is literally the price of the company in ratio to its annual revenue. Unlike P/E, it can be applied to losing companies. A P/S value below 2 is considered good, and the higher it is, the worse investment this will be. An almost perfect value is one.
P/BV (Price to Book) shows the size of the company's assets minus its commitments (debts). The multiplier compares the company's capital to its capitalization in the stock exchange. A P/BV value of 1 means that currently, its stocks cost less than in the exchange (are undervalued). If the value is between one and zero, the company is overpriced. If the multiplier is zero, this means that the company is not all right, and you should better ignore this investment opportunity.
Using multipliers, investors usually compare several companies from the same sector. For the estimation, the report of the previous period, current period, and forecasts are used. By comparing the data, we can conclude which company is more attractive for long-term investments.
Peculiarities of multipliers
If you use multipliers, you need to take into account the following:
- For new and developing companies, multipliers can be faulty.
- You cannot estimate the company by just one index; your approach must be complex.
- Comparing companies from one sector, take notice of their business, the number of employees, and debts.
There are plenty of resources for calculating multipliers on the Internet. See below which indices you can use on Finviz.com (the data is given for clearness).
On the website, you can single out companies depending on their business, stock price range, and the country of registration. Mind that it is for the investor to decide which data to base their decision on.
Making investment decisions
Upon analyzing the multipliers, there is one main thing to do — to make the right decision. In this case, intuition plays one of the most important parts. However, I will talk about something else.
Having analyzed the data, find out what the company does and when it was founded. Young (fresh) companies can yield quick profits but entail increased risks. I suggest investing in companies that had an IPO over five years ago.
The number of employees is also important, and the larger it is, the better. Large companies have fewer chances for bankruptcy than small businesses (there are exceptions, nonetheless, check this parameter).
An example of an investment portfolio
See below an example of capital distribution in an investment portfolio. Take 100% of your investments and distribute them between sectors that are the most attractive for us.
This list is just an example rather than an instruction:
- Heavy industry — 15%
- Cargo transportation, ground, air, water transportation — 15%
- Finance — 15%
- ETF — 15%
- Bonds — 15%.
This does not mean that you invest your 15% in one instrument from each sector; instead, you can choose 5-7 companies (choose the number based on your needs) that have satisfactory parameters and look attractive. The remaining capital will remain free so that you could diversify risks or buy more assets.
What an investor should not do
When investing, make sure you are not using speculative principles:
- Do not aim at momentarily profits, you are not speculating.
- Do not use leverage or loaned money.
- Trading news does not suit an investor because, on news, the price of assets can be extremely volatile, which might influence your decisions.
- Leave oil to speculators (metals are a separate issue).
- Make decisions based on your own analysis rather than other people's advice.
- Short trading is your enemy. Many companies grow in the future, while it is hard to predict your losses in sales. Here is an example: A trader bought (opened a buying position) 100 stocks in A company for 10 USD each. Later the company went bankrupt and the stocks dropped to zero. The losses of the trader will amount to 1,000 USD or 100% of their investment (the stocks reached the bottom). If the stock price grows, the trader makes a profit, closing the position. However, the size of the profit is unknown.
Here is an opposite example: a trader opened a selling position, i.e. sold 100 stocks for 10 USD each, and their price started decreasing. In this case, the trader makes money, their maximum profit will amount to 100% (conditionally) of their investment. If the stock price starts growing, where will it stop? This question has no answer, so your loss might be over 100%.
Diversify your risks: form your portfolio by stocks from different sectors, ETFs, and bonds.
Investing is passive income, and this is what most traders dream about, perhaps even most people; however, not everyone really succeeds. An investment portfolio takes more than a day to comprise.
Based on multipliers, you can compose an investment portfolio for the long run, using your knowledge of what the multipliers mean. Never forget to compare companies with each other and the average values of the sector.
In open sources, the portfolios of market "whales" are open to the public. Study them and choose something attractive for you. Do not be afraid of investing just by small sums at first, in the future, this might become your main source of income.