Stock Investing Tips for Beginners – How to Know When a Stock is Too Expensive

If you’re a new stock investor, like I am, or if you’re trying to learn stock investing, it will be to your advantage to understand the basics.  When I started investing in stocks a few months back, the most difficult part came when I needed to choose which stocks to buy.

As I mentioned before the stock market, like any other market, showcases the prices of stocks. You wouldn’t know, based from this basic information, whether or not a stock is worth its price until you dig a little deeper.

When I faced this particular problem, I decided to do a little research. I was lucky to come across “The Intelligent Investor” which is a book I have since used as my guide to stock investing decisions.

Stock Price Guidelines

In a previous article, I wrote about how the author (Benjamin Graham) made a series of guidelines for a defensive investor on selecting which stocks to buy. One particular guideline that he mentioned involves setting a limit to stock prices. There are stocks that are just too expensive for their worth.

I have written about the book value of stocks. I have said that a defensive investor (following “The Intelligent Investor”) ought to limit the price he should pay for a stock to about one and a half times the book value.

Now I want to go a little deeper and discuss the remainder of that guideline. That’s because the author coupled the book value as a basis for price limit with the company’s earnings performance.

What does that mean?

It means that besides capping the stock price to one and a half times the book value, it is also recommended that the price be not more than fifteen times the earnings per share (EPS) of the company’s stock for the last 3 years.

To understand that a little more, it would help to know what earnings per share (EPS) is. If I had to put it in a formula, it will look like this:
This should help you appreciate that we are concerned primarily with the portion of the company’s earnings which we can allocate to outstanding shares of common stock. That’s done by taking away the dividends paid to preferred stocks.  If you don’t understand what a preferred stock is or why we have to subtract it’s dividends, set that aside for now.  I can expound on it later.

You just need to understand that EPS is an indicator of the company’s profitability. The more the earnings per share is, the better it would be for investors of its stocks. Conversely the lower the earnings per share of stock, the less attractive it would be for investors to buy it.

However, EPS is a number that’s hard to assess in itself.  The common method used to benchmark the EPS is by comparing it to the stock price. Dividing the stock price by the EPS will give you another indicator called the price-to-earnings ratio or P/E ratio.

Discerning the Ratios

Obviously you’d want the E to be high in this relationship. It’s also ideal for the P to be lower for the stock to be an attractive investment.  It seems difficult to make an assessment by just looking at price and EPS individually that’s why the P/E ratio came to being.

The price of any stock you consider buying shouldn’t be too high that it’s greater than 15 times the earnings per share.  Or the earnings shouldn’t be too low that the price overtakes it by more than 15 times.

All these discussions would give us two specific guidelines to help us assess the price of stocks.
  • Price-to-Book value should be at most 1.5
  • Price-to-Earnings ratio should be at most 15
Take note that these guidelines for stock prices go together. The author, however, suggests that they shouldn’t be so inflexible.  You may allow one of these two metrics to go beyond the limit but you need to make sure that their product stays behind 22.5.

That’ll help you to avoid buying stocks that are too expensive.  If you’re new to this, it wouldn’t hurt to make sure you protect yourself by mitigating the risk you’re going to take.

Photo Credit: Walter Rodriguez (Creative Commons)

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