How to value investments
That old maxim of buying low and selling high is a lot tougher when investors don’t know whether an investment’s value is high or low. As Brian Kilb explains in a Money Talk Video, one way to find an objective valuation is through the ratio of price to earnings. Here is a transcript of the video.
Most investors have great difficulties grasping what value to put on their individual stock or on the marketplace.
Like so many other markets, you wouldn’t go in and make a purchase without having some idea of what you think it’s worth. It’s that “what it’s worth” part of the equation that investors get so wrong, so often, because they don’t have an objective measure on which to compare what the market is telling them.
That’s where having objective data is essential to making intelligent investment decisions.
There are many, many different ways people in this industry have created over the years to determine value. Some are very simple. Some are very complicated.
A very simple way for investors to grasp an overall valuation of the markets is to look at the price-to-earnings ratio. How much in price – dollars – do you pay for each unit of earnings? The price-to-earnings ratio over time for the S&P 500, for instance, is around 15.
So if you were to take the projected earnings – either looking 12 months forward or looking 12 months backward – and then divide by what the current value of the market is, you’ll get that ratio. If that ratio is less than the historical norm, you might consider the market cheap. Conversely, if that ratio is greater than the historic norm, you might consider it to be a bit overpriced and shy away from purchases.
By using objective data such as these earnings or other measurements, it takes some of the ambiguity out of the investment decision. It gives you hard data on which to make these decisions.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Landaas & Company video by Peter May
(initially posted May 9, 2013)
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