In Lesson 11, we looked at how to select a company to invest in, lets consider this week how to pick stocks to invest in. this week we conclude on stocks.
Lets look at a ratio called the Price Earnings Ratio. The P/E ratio divides a stock’s share price by its earning per share to come up with a value that represents how much investors are willing to shell out for each dollar of a company’s earnings.
So the stock price is N50 the earning per share is 10, the PE Ratio is 50/10 or 5
The P/E ratio allows you determine how much or earning your are paying for at the market price. In our example, at the market price of N50 your paying 5 times the earning or the company, or the multiple is 5.
The PE also tells you how long you will have to wait to receive your investment back. Again from our example, your N50 investment at the current level of earning will be repaid in 5 years.
A stock with a lower P/E ratio costs less per share than a stock with a higher PE. So you want to look at low P/E when buying shares. So if Share A with a market price of N100 has a PE of 10 and Share B with a market price of N50 has a PE of 30…Share A is “cheaper than Share B…
Keep in mind, you compare PE of stock sin the same sector, so banl stock to bank stocks
So how do we determine value? Or how do we select a company to invest in?
Remember a share is simply that, a share of a company’s profits for life, a simple way of pricing a share is
Get the risk free rate that corresponds to how long you want to hold the stock eg 1 year, will be 8% in our yield curve.
Get the earnings per share of the share you want to buy eg N2.00 per share (its usually published in most business papers)
Divide 100 by the risk fee rate, eg 100 divided by 8% for a year 12.5
Multiply the answer in (3) by the Earnings per Share eg 12.5 x N2 equals N25
This means that by earnings, the price of the share should be N25 because if you invested N25 in a T-Certificate paying 8% you will get N2.00. So you wanna buy a share do this above and then know how much extra you are paying.
If the price is above N25…don’t buy because the market price is above your valuation.
Ok let me give you rules on how to trade in stocks…
- Get advise
- Buy what you know, I you don’t know how a company makes money, don’t invest in the stocks.
- Favor stocks with low PE ration, not just lower price this means your buying stock at a lower multiple
- The profit on trading in stocks is made when the stock is bought, so buy stock at a big margin between intrinsic value and market price
However, lets assume your want a disciplined method to invest in the stock market, there is let me give you the steps
- Get the yield of the 1 year Govt Bond, also get the yield on the NSE All Share Index. If the yield on the Govt bond is higher then, don’t invest in equity, simply invest in the govt bond. Why? It’s a higher yield , risk free.
- If the yield of the NSE is higher Get the top 40 stocks
- Rank in order of dividend yields i.e. div/ market price
- Get top ten ranked stock by dividend yield, eliminate the rest.
- Rank selected stock in order of lowest price
- Buy from the top listed stock to the lowest, ie start investing from stock with lowest price and highrst dividend yield
Dividend yield method allows you invest in good value stock when they are out of favor. i.e. buying low
ok we end here, we talk about Estate Planning, protecting your assets next…
