The most important thing to understand about picking stocks is this: If you are buying a stock, someone else is selling it. Whatever analysis you have done to tell you that this stock is a good deal at today’s price, be aware that there is someone else on the other side of the trade who has run the numbers and decided that the smart move is to get out now. Stock picking is a battle of wits against other investors, most of whom, you should assume, are at least as informed and rational as you are. That’s why it is difficult for even pros to beat the return they’d get simply from holding an index fund.
But investing in stocks can be exciting, and an intellectual challenge. The basic formula for stock analysis is simple: Pay a price that’s less than the long-term, per-share value of the underlying business. The art of investing is in figuring out how to determine that value.
“Growth” investors tend to focus their analysis on a company’s potential for future profits, and gravitate to those whose earnings are rising the fastest. Often these stocks have a highly compelling story: Maybe the company sells a hot new tech product or the next blockbuster drug, or has found an innovative new way to sell fast-food burritos. Since growth-oriented investors are interested in big future earnings, they are often willing to pay a high price for a stock relative to what it earns right now. The price-to-earnings ratio, or P/E, is a common metric for valuing stocks; growth investors will often be willing to pay P/Es of 20 or more.
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“Value” investors bank less on future potential. They’ll tend to hone in more than growth investors on the current value of a company’s assets (minus its debts), and look for stocks that are cheap compared to those assets. And since they don’t want to count on the most optimistic forecasts for profits, they usually buy stocks with lower P/E ratios.
Intuitively, value sounds like a more conservative approach. But value stocks can go out of style for long stretches of time, and buying cheap comes with its own risks. Often when a stock appears to be a bargain, that’s only because other investors correctly see that the business has serious problems. Alas, there’s no one simple formula that tells you when a stock is great deal. You have to dig in, do the research and make a judgment call.