Companies increase revenue by increasing prices of their goods and services. Every year, we consumers pay more and more, complaining how everything has gotten more expensive. But if you’re an investor, you might have thought of the situation differently. Higher priced goods suggest high revenues (assuming no change in sales volume), potentially translating into better earnings for the company.
As the earnings of the company increase, investors are more willing to price in future earnings growth, thus bidding higher for the company’s stock. If you read our article on Price-to-Earnings ratio, you would understand how this phenomenon would play out. To maintain the same P/E valuation when earnings are growing, the share price must follow suit.
Courtesy of Guerillastocktrading.com
Wow, so that’s the answer? Just buy a stock at any price, hold and wait for it to go higher? OF COURSE NOT. Here’s when I must quantify! This applies ONLY to good companies with healthy balance sheets, cash flows and fulfill all other financial ratios. There are a multitude of ways to analyse a company and we have written several articles which you can check out!
- CapitalistLAD Guide to Ratios: P/B Ratio (Part 1)
- CapitalistLAD Guide to Ratios: P/B Ratio (Part 2)
- CapitalistLAD Guide to Ratios: P/S Ratio
- Cigar Butt Investing Decoded
- Investing in Companies with Economic Moats can give you an Edge
- CapitalistLAD Guide to Share Dilution
- Invest using SWOT and Porter’s 5 Forces
If you’re new to stock valuation, you might find it difficult to filter out the GOOD companies that I’m talking about. But this is no excuse not to get invested. You can invest in the broad market by buying an Index fund. So long as you subscribe to the belief that the economy that you’re a part of will continue to perform well over the LONG RUN (not telling you to speculate short-term moves), then you can invest in the economy through an index fund. Not only are you well-diversified across multiple industries which helps you mitigate unsystematic risks, you do not need to pay high management fees like most other active funds.
If you’re serious about stock valuation, a must read would be The Intelligent Investor by Benjamin Graham. Of course, catch up on our previous company analyses articles as well!
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Till next week, have a good weekend!