Valuation indicators (1/9)

Valuation ratios are financial indicators that enable us to form an opinion about the relative cost of a stock. When you want to buy a stock, one of the first things you look at is its price. Is it expensive? Cheap? Relative to what? Is it a two- or three-digit number, or is it a penny stock? Has the price fallen recently, or has it been on an upward trend for some time?

None of this means much in itself. Paradoxically, a 50-centime share can cost you a lot more than a 2,000-centime share. For example, an A-share in Berkshire Hathaway, the company owned by the famous Warren Buffett, currently costs over 280,000 USD. So, yes, that's a lot compared to the financial resources of the average person. But the question is: is it expensive compared to what it's actually worth? It's certainly less than Tesla which is currently quoted at USD 320 and is only making losses.

Falling knives, rising rockets... or keep your feet on the ground with valuation ratios

In the same vein, this just because a share price has fallen sharply doesn't mean it's a bargain. It's often said in the stock market that you can't catch a falling knife. Most of the time, this is invaluable advice. Those who, like me, thought they were getting a good deal with Swissair learned this the hard way. And yet this company was considered one of the best airlines in the world.

Conversely, others follow a strategy known as "momentum", i.e. buying in line with the trend, and thus buying at the top. Research has shown that this approach works, but that the effect is short-lived. This is due to the time it takes for information to spread, from insiders, groups of friends, colleagues, professional investors, institutional investors, to the mass of investors. This means that if you buy a company whose share price has risen sharply in the last 6 or 12 months, you have to sell it in 6 or 12 months. After that, there's a good chance you'll lose out.

If price in itself doesn't mean much, how do you know if you're buying expensive stock or not? It's a bit like going to the fruit and vegetable market: you have to feel what you've got, smell it, look at it - in short, make sure you're getting value for money. In the stock market, this means looking at sales, profits, dividends, cash and assets. From this we can deduce fairly simple valuation indicators which can be of great help to investors, but which paradoxically few of them bother with. That's unfortunate for them, but fortunate for us...

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