Online Investing Hacks

Use Rational Values to Buy and Sell Wisely

By determining the rational value of stocks, improve your investment results by keeping emotions out of your buy and sell decisions.

It’s really tough for an investor to remain upbeat and hold investments whose prices are plummeting in the throes of a down market. And it’s equally difficult to be realistic and patient (the cornerstones of successful investing) when the stock market is soaring. By assessing the rational price of a stock and the rational value of your portfolio, you can make sensible choices when others overreact.

Many shareholders fail to realize that there is a finite, absolute—though approximate—value for each share of stock. When viewed over a five-year period, the short-term ups and downs of a stock’s price generally vary on either side of a value that’s tied to the earnings of the underlying company. When you select successful companies capable of growing their earnings at a substantial rate, the underlying value of your shares should climb as well.

The relationship between a company’s earnings and its stock’s price is measured by the price to earnings ratio [Hack #27] and is calculated by dividing the price of a share of the stock by the company’s earnings per share. Called the P/E ratio or multiple, this value is similar to the price per pound of coffee or gallon of gas. The P/E ratio is the price investors are willing to pay for a dollar’s worth of the underlying company’s earnings.

The Signature PE

Because it fluctuates ...