The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere

Chapter 8. Brought To You By The Letter "V" (For Valuation)

Even if a carpenter finds the hammer to be his favorite tool, he never comes to the job with just a hammer (at least not intentionally, not if he is sober). He brings his toolbox with a full set of tools in it.

It's the same with investing: You have many valuation tools at your disposal, and they all have advantages and drawbacks. However, by using them in concert with one another and by being aware of their strengths and weaknesses, you can make a more accurate valuation of any given company.

Beyond the Hammer

Relative valuation tools such as price-to-cash flow, price-to-earnings (P/E), price-to-sales, price-to-book, are good, quick, and easy shortcuts to analyze and screen stocks. Their ease of use have made them very popular among investors. For simplicity in this discussion I'll use P/E (the most popular of the bunch) to demonstrate the application of relative valuation tools and their use in the sideways markets.

Relative valuation analysis allows investors to see how a company's current P/E stacks up against competitors, industry averages, and the market. It also allows for historical comparisons. The P/E ratio is an important tool, if for only one reason—almost everybody uses it. The market has a view on stocks, and it expresses that view in the price it pays for a unit of earnings.

A value investor buying a stock wants to assess whether the stock is cheap or expensive. One way of doing it is to see at what P/E this company ...