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Stock Market Trading Strategies and Valuation Methods

Updated on September 20, 2015

Stock Market Trading Strategies and Valuation Methods

A picture of the floor of the New York Stock Exchange (NYSE)
A picture of the floor of the New York Stock Exchange (NYSE)

Before delving into the world of stock market trading and investing, it is advisable to understand the basic stock market trading strategies and valuation methods that stock market traders and investors use and to trade and invest in the stock market.There is a lot more to stock market trading and investing than just buying and holding stocks.

What is commonly called the “Stock Market” is actually a number of stock markets, which are in turn made up of thousands of publicly issued stocks that represent equity ownership in companies and are traded on the various stock markets.There are stock markets in all developed countries throughout the world and in many developing countries.

Common Stock Market Stock Market Trading Strategies and Valuation Methods

The most basic stock market trading strategy is known as buy low and sell high. Traders buy stocks with the intent of making money, which means buying an undervalued stock when it is low, and selling it when it is high. This strategy can also work in reverse, as a sell high and buy low strategy, when traders borrow an overvalued stock and sell it short, and then buy it back at a lower price at a later date.

Buying low and selling high, or implementing the reverse strategy by shorting stocks, takes conviction and a contrarian inclination, since the best times to buy or sell short stocks are often when the herd of stock market traders and investors are going in the opposite direction. There’s an old saying on Wall Street, “buy stocks when nobody else wants them”. This is perhaps the best stock market advice of all, since eventually the economy will grow again, companies will report growing earnings, and stocks will respond by moving higher. It is a good idea to average in when buying a stock position during times of uncertainty since picking the absolute bottom in a stock is nearly impossible. Patience and conviction are the keys to buy low and sell high trading and investing.

Another stock market strategy that may seem counter-intuitive is to buy high and sell higher. This stock market trading strategy works during bull markets when earnings and stock prices are increasing and stock market sentiment is positive, and involves buying stocks that have high earnings growth rates (see the PEG ratio valuation method below). Stocks that are candidates for the buy high and sell higher strategy may have already made significant moves higher, but can still be relatively cheap on a forward looking earnings basis with room to move even higher (see Future Earnings Growth Is More Important Than Price).

Common Stock Valuation Methods

There are a number of valuation methods used by stock market traders and investors to assist them with assessing the actual intrinsic value of a stock, as well as the overall stock market, so they can make sound investment decisions. An easy to understand valuation method is the widely utilized price-to-earnings ratio (P/E ratio) stock valuation method.

The P/E ratio is a value that is calculated by dividing the current price of a stock by the total of the past year of reported company earnings per share. For example, if XYZ Inc. is selling for $80 per share, and it reported earnings of $10.00 per outstanding shares over the past year, then XYZ Inc’s stock has a P/E ratio of 8.

Average P/E ratios can vary quite a lot amongst stock market sectors. For example, a P/E ratio of 8 would be extremely low in the high growth high technology sector of the stock market, but would be close to average in the low growth banking sector. A bullish or bearish stock market and the state of the economy are also factors that affect the relative value of a stock’s P/E ratio and the overall stock market P/E ratio.

As a general rule of thumb, the average P/E ratio for the entire stock market over many decades going back to the 19th Century is 15. Stock market analysts and participants generally consider a stock market with an average P/E ratio below 15 to be undervalued and a stock market with an average P/E ratio above 15 to be overvalued. However, due to the many factors that affect corporate earnings, such as economic growth and interest rates, the average stock market PE ratio can sometimes reach levels that are far below or above the long term average of 15.

A major criticism of the P/E ratio stock valuation method is that it is backward looking, since it is based upon the past year of company earnings per share. Past performance does not predict future performance, and this is true of company earnings. For this reason, it is a good idea to use the P/E ratio stock valuation method for general guidance regarding valuation, and then to look at a variety of other factors that may affect a stock’s share price going forward, such as forward earnings per share (EPS) guidance and the economic outlook, before deciding whether a stock or the stock market is a good value and worth buying.

The PEG ratio is a useful stock valuation method because it provides guidance regarding a stock’s value in relation to its earnings growth rate, which is the primary factor that drives stock prices higher. To calculate a stock’s PEG ratio, divide the stock’s current P/E ratio by stock analyst’s consensus regarding the forward earnings growth rate for the year ahead.

PEG = Price / Earnings / Annual Earnings Per Share Growth Rate

A PEG ratio above 1 indicates a stock that is overvalued relative to the future earnings growth rate, while a PEG ratio below 1 indicates a stock that is undervalued relative to the future earnings growth rate.

For example, if ABC Inc’s stock has a P/E ratio of 20, and is growing earnings at only 10% per year, then the PEG ratio is 2.0, which indicates the stock is overvalued relative to future earnings growth, and its prospects of moving higher based on earnings over the next year are not good. However, if ABC Inc’s stock has a P/E ratio of 20, and is growing earnings at only 30% per year, then the PEG ratio is 0.66, which indicates the stock is undervalued relative to future earnings growth, and its prospects of moving higher based on growing earnings over the next year are favorable.

Other common stock valuation methods include (but are not limited to):

  • Forward Earnings Per Share (EPS) Estimates – While important to consider when valuing a stock, forward looking earnings estimates are notoriously unreliable due to unforeseen factors, such as economic recessions, that affect future earnings.
  • Earnings Yield – The Earnings Yield valuation is calculated by taking the earnings per share for the past year (or twelve month period) and dividing the earnings per share by the current market price per share. Earnings Yield is the inverse of the P/E ratio, and while a useful valuation metric, like the P/E ratio it is a backward looking valuation method that does not take into account potential changes in future earnings or future earnings growth.
  • Book Value – Book Value is a valuation metric that looks at the intrinsic value of a company, which is calculated by adding up total assets of a company and subtracting intangible company assets (such as patents with unknown valuations and goodwill factors such as brand name) and liabilities. Book Value is particularly useful when trying to value companies that are in distressed situation to assess what they are actually worth.

Beware of Value Traps

It is important to beware of value traps in the stock market. Value traps are stocks that appear inexpensive from the perspective of their current P/E ratio and price, but are not inexpensive when future earnings (or lack of future earnings) are taken into consideration. Declining earnings will lead to a rising P/E ratio, which will hinder the stock from rising in price in the future due to declining valuation. If a company reports losses instead of earnings, the P/E ratio will disappear, which is negative for a stock’s valuation and future prospects for an increase in price.

Future Earnings Growth Is More Important Than Price

It is important to keep in mind that future earnings growth is the most important metric when valuing how inexpensive a stock is and what the prospects are for a stock to move higher in price. This is why the PEG ratio is such a useful valuation method. The cheapest stocks in the stock market are actually the ones that have good projections for futures earnings growth, and are not the necessarily the stocks that trade for the lowest prices and appear cheap.

The stock market is always looking out at least six to nine months into the future, which means any evaluation of future earnings growth should also look out to this time horizon and beyond. Stocks that are projected to accelerate earnings in the future or are projected to experience a turnaround in earnings are the stocks most likely leads to trade higher in the future. These are tried and true stock market trading strategies and valuation methods.

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