iBooyah.com: Homework matters
What separates an investor from the fools is our knowledge. Knowledge keeps us safe from our own foolish impulses. The impulse to sell when we believe the sky is falling or buy when we believed we are about to miss the boat is inherent in all of us. As a result, we end up buying high and selling low. We all make this mistake from time to time. The only thing that can keep us from this mistake is to understand what you are buying.
The importance of doing your own research and understanding the fundamentals cannot be stress enough. Before you commit your hard earned money to any stock, make sure you understand what you are getting yourself into. The first thing is to understand the business and how the company is generating revenue. While this sounds easy enough, most individual investor seldom takes the time to research the company before buying. For example, if you are interest in buying shares of an internet company, make sure you understand their business model. How are they generating revenue? Is it from advertising or through product or services? Is the revenue model sustainable? A simple method is to evaluate the company’s Strength, Weaknesses, Opportunities and Threats (SWOT). If nothing else is done before buying a company’s stock, take the time to consider the company’s SWOT.
Once there is an understanding of the company’s fundamentals, it is then time to look into the technical. One ratio to investigate is the price to earnings ratio. This is commonly known as P/E ratio. This ratio is calculated by taking current price of a stock and dividing it with the earnings per share (EPS). For example, take company XYZ, if a company is currently trading at $29.70 and has an EPS of .85, the P/E ratio is 34.5. If this company year over year growth rate is 17%, we would say this company is trading at 2x the expected earning. The P/E ratio is important since it helps us gauge the “fair price” of a given stock. Keep in mind, most growth stock will typically have a high P/E ratio as the market expects their growth rate to be higher than the typical “mature” companies.
The P/E ratio alone does not do us any good when trying to determine if a stock is trading at fair value, however. To help determine the value, we must compare the P/E ratio with its peers. If company XYZ competes with company ABC, compare their P/E ratio. Again, the company that is perceived to be a growth stock will usually have a higher P/E ratio. Be careful when buying these types of stocks as the expectations are high and if the company does not exceed expectation, the stock will likely fall. A recent example of this was StarBucks (SBUX). The company reported a great quarter, but failed to meet the high expectation and the stock tumbled.
In conclusion, knowledge is the key to being a successful investor and can only be gain through homework. Knowledge provides us with the courage to buy more position when others are panicking. Best of Luck!
