As you begin investing and you see the market rising and falling every day, you’re probably wondering: How in the world do you figure out when to buy and when to sell?
There’s a little science to it, and a lot of art.
My goal in setting a preferred buy-under price is to lock in the best possible total return (dividends plus price gain). So I look forward 12 months. I ask myself: Given the investment’s current price, what kind of return can we expect in the coming year?
The answer depends on a variety of factors:
Projected Earnings Growth
Projected earnings growth is how much analysts expect the earnings per share (EPS) to rise or fall for the year or for the quarter. Of course, we would much prefer a stock that is projected to grow. You can find the projected earnings growth on the Analyst Estimate section of sites like Yahoo Finance, Morningstar or Google Finance.
For most stocks I’m looking to buy, I prefer that the projected earnings growth rate in the year ahead exceeds that of the S&P 500 Index, the generally accepted benchmark for the overall market. Thus, if the analysts are expecting the S&P’s earnings to grow 5% this year, I focus on companies with an estimated growth rate of more than 5%.
P/E Ratio
The price-to-earnings, or P/E, ratio (stock price divided by EPS) is one way to tell if a stock is over- or undervalued. A high P/E indicates that investors expect growth in the share price. To compare P/E ratios within a sector, you can use the Related Companies feature of Google Finance.
Click to Enlarge For example, as you can see in the screencap, Fossil (FOSL) has a higher P/E ratio than others in the retail sector. Some stocks do not have a P/E ratio if they are losing money.
You can expect that faster-growing businesses will command higher P/Es. To make sure you aren’t overpaying for growth, compare the P/E with the company’s projected growth rate for the next five years (also available on the Web sites I just mentioned). Ideally, this so-called PEG ratio (P/E divided by growth) shouldn’t exceed 1.25. PEG ratios below 1 often represent mouthwatering bargains.
Dividend Yield
Dividends are income that you receive (usually quarterly) in addition to any gains in the stock price. It comes from a portion of the company’s earnings. Not all stocks pay a dividend, and the ones that do are usually more established companies that can afford to do so.
Young investors should generally steer away from the highest-yielding stocks (those with a dividend yield above 4%) because such companies are usually growing too slowly for an investor with many years to retirement. Typically, I find that stocks paying 1% to 3% in dividends provide the most consistent long-term growth. These stocks also treat you more gently than non-dividend-paying ones during the market’s inevitable rough periods.
Historical Volatility
Volatility, as you can likely guess, is how unpredictable a stock’s moves are. For peace of mind, you may prefer stocks with low volatility, but stocks with high volatility (depending on the strength of the business) may also show a surprise upside move.
The most widely available measure of volatility is beta. (You can find a stock’s historical beta at the Web sites I previously mentioned.) If a stock has a beta of less than 1, the share price has historically fluctuated less than the market.
I generally favor low-beta stocks because they let me sleep better at night. However, in the early stages of a bull market (as in 2009, for example), high-beta stocks will give you more punch on the upside. So it’s OK to own some high-beta stocks, too, but only when you’re pretty sure you’ve got the market’s wind at your back.
So After You Run the Numbers …
If it seems that the stock, at its present level, is unlikely to outrun the market indices over the next 12 months, I would advise buying below today’s price. (“Wait for a pullback” is the well-worn phrase.) On the other hand, if the stock appears capable of beating the indices from here on, it’s OK to buy even somewhat above today’s price.
A good way to get some idea of a stock’s near-term potential is to look at the analysts’ target price 12 months out. (As far as I know, the only website that provides this information is Yahoo Finance.) Let’s say the analysts are projecting $34.79 for Microsoft (MSFT) in 12 months and the stock is currently at $31.50. That means analysts are estimating a 10.4% price gain in a year. Add in a 2.9% dividend, and you get a total return of 13.3%.
For most stocks, I like to buy at a projected total return of at least 15%. (With utilities and other slow-and-steady movers, I may accept as little as 12%.) Thus, in the case of Microsoft, I would set my buy limit around $31 to nail down a projected return of 15%.
Subscribers occasionally express surprise when I lower a buy limit. It’s no mystery, though. Businesses, like people, run into unforeseen difficulties. If a company’s operating performance hits a rough patch, you can’t expect its stock to behave as well as it did before — certainly not until management takes steps to resolve the problem. In the interim, it’s only reasonable to demand a lower stock price to reflect the changed circumstances.
When deciding which of several recommended investments to buy, I suggest that you begin with the names furthest (in percentage terms) below your buy limit. If you’re looking to sell anything — perhaps because you need the cash, or because you like to trade more actively — start with the investments furthest above that limit.
By following a disciplined approach, you’ll put acres of daylight between yourself and the legions of investors who let their emotions rule.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won seven Best Financial Advisory awards from the Newsletter and Electronic Publishers Foundation.
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