Imagine your average trip to the grocery store. You go through the ads and various coupons and figure out what items are on sale. If there are products that you have a preference for, you will go ahead and buy them for a bargain. It makes sense. When you like a product and see it selling at a lower price than usual, you will buy it. That begs this question: why should the approach the stock market any different?
When buying stocks, the first thing you want to do is identify companies that you like. Good companies can be defined in any ways. This depends on personal preference, but for me, a good company is one with good management in place. In addition, it is a company that has had steady growth over the years. Companies that have historically paid dividends are also another plus in my book. Finally, invest in what you know. Peter Lynch advises this in his book “One Up on Wall Street” which provides great insight on how he made 29% a year over the span of 20 years.
I suggest that you make a list of good companies that you like based on the criteria above. It doesn’t have to be a long list, be it should be long enough so that it gives you options in investing. Track of these companies over time. When these companies become “cheap” buy as much stock as you are comfortable buying. Cheap can be defined in any number of ways. I personally view cheap companies as one that have a low PE ratio. A low PE ratio has historically been one that is under 15. I use this as a base for deciding the value of a company. I also compare their PE ratio to the historical PE ratio of the company as well as the average PE ratio for other companies in their industry. You can also use price-to-book ratio and price-to-sales ratio when valuing a company.
When you combine you knowledge of great companies with the valuation metrics, you will greatly increase your chance of succeeding in the stock market. As Warren Buffett once said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”