Be picky about valuation. You'll do well over the long haul by buying
companies that are undervalued relative to their earnings potential.
• Don't rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you're assessing a stock.
• If the firm is cyclical or has a spotty earnings history, use the price-to-sales
ratio. Companies "with P/S ratios lower than their historical average can
sometimes be bargains.
• The pricc-to-book ratio is most useful for financial firms and firms with
numerous tangible assets, and it's least useful for service-oriented firms.
In addition, firms with higher ROEs will typically be worth a higher
P/B ratio.
• You can compare a company's P/E with the market, with a similar firm, or
with the company's historical P/E. In each case, you'll want the company's
P/E to be lower than the benchmark, but make sure you're aware of any
differences in risk or growth rates between the company you're valuing
and the benchmark. The most reliable benchmark is likely to be the com
pany's own historical valuations, assuming the company hasn't changed
very much over time.
• Use the PEG with caution because fast-growing firms also tend to be
riskier. Don't overpay for expected growth that may never materialize.
• The lowest P/E isn't always the best. Firms "with high growth, low risk, and low capital reinvestment needs should have higher P/E ratios. You'll likely be better off in the long run paying more for a low-risk firm that's generating large amounts of cash than paying less for a cyclical company that's very capital intensive.
Check the earnings yield and cash return, and compare them with the
rates available on bonds. An earnings yield or cash return above current
bond rates can indicate an undervalued stock.
