We all know it is important to select a good company worth investing in, but is that all?
If you buy the shares of a good company, does that mean you can rest assured, do nothing about it, and wake up finding yourself a millionaire?
A good company does not necessarily come with a fair price.
For example, $Amazon(AMZN.US)$, an outstanding company showing impressive growth in both business and stock price, may not be a good investment choice at the end of 1999.
If you bought $Amazon(AMZN.US)$ stock in 1999, you would ride on a roller coaster from over $100 to less than $10 after the burst of the dot-com bubble.
It would take 10 years to recover the initial investment.
Can you wait a decade for a stock to rebound?
'Just hang on, hang on...' That's what you tell yourself. But when you suffer a 90% loss, your answer may be a no-no.
In fact, Warren Buffett already gave us a tip, and he said, 'Buy a wonderful company at a fair price.'
So the question becomes how can we tell if a stock is at a fair price?
To help your understanding, let's take a look at the following example.
Suppose there are two cafés named Bull Café and Bear Café.
The annual profit is $200,000 for Bull and $50,000 for Bear.
Both cafés are for sale now. Bull is sold at $1,000,000, while Bear is sold at $500,000.
Which café would you buy?
To figure this out, let's take a look at one of the most widely used valuation metrics: the price-to-earnings ratio, or P/E ratio.
Basically, a company's P/E ratio tells us how much its investors are willing to pay for every dollar earned by the company.
Now let's go back to the example of cafés. Bull is sold at $100,000,000 and has an earnings of $200,000.
So its P/E ratio is 5 times.
Likewise, we can calculate Bear's P/E ratio, which is 10 times.
This means if you decide to buy Bull Café, it will take you 5 years to recover your initial investment.
If you buy Bear Café, the number would be 10 years.
By comparing the P/E ratios, we could tell that Bull Café may be a better buy.
Normally, the higher the P/E ratio, the more likely that the stock is overvalued, and vice versa.
Now you may probably ask, 'What if a company has no earnings? How can I tell if its stock price is overvalued or undervalued?"'
In most cases, even if a company's in a loss, its book value, which is equal to the total assets minus total liabilities, is still positive.
As P/E ratio no longer works in this case, we need to use price-to-book ratio, also known as P/B ratio, to evaluate the relative value of a stock.
We still use the example of cafés to explain P/B ratio.
Suppose the book value is $1,000,000 for Bull and $250,000 for Bear, and their selling prices remain unchanged.
In this case, the P/B ratio for Bull is 1 time, for Bear is 2 times.
A high P/B ratio is usually interpreted to mean that the stock is overvalued compared to its book value, and vice versa.
By comparing the two cafés' P/B ratios, we could tell that Bull delivers greater value for money, as you will be paying less for every dollar of its net assets.
With moomoo, you can find out a ticker's P/E and P/B ratio by simply tapping the ticker in your watchlist and tapping anywhere above the dividing line to display more info about the ticker.
If you'd like to find out a stock's historical P/E and P/B ratios, you can go to Detailed Quotes, tap Analyses, select Fundamental, and then tap Details.
To conclude, a wise investment decision takes into account two important factors, i.e. a wonderful company and a fair price.
In share dealing, using metrics like P/E and P/B ratios could help us better understand whether a stock is a great buy.
Through this lesson, we hope you are better familiarized with the two metrics. If you'd like to gain more stock trading knowledge, stay tuned with us! In the next chapter, let's explore the secret behind charts!
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