In order to make money in the stock market, investors need to choose stock that will increase in price over time. One way to do this is by choosing stock that is selling for less than it is worth. This type of stock is known as undervalued stock. The idea behind investing in undervalued stock is that the price of this stock is more likely to rise over time because it is being sold for less than its worth.
On the other hand, most investors like to avoid overvalued stock, which is selling for more than its intrinsic worth. Many successful investors have relied on identifying value stock in order to make money.
Warren Buffett and Value Investing
Billionaire investor Warren Buffet takes an approach to investing where he focuses on buying undervalued stock. Following this model, the stock price increases over time, and Buffett makes a profit. Buying stock based on whether it is overvalued or undervalued is known as value investing. The premise is that it doesn't matter what the rest of the market is doing; it only matters whether you are buying a stock for a bargain (an undervalued stock) or whether you're paying too much (an overvalued stock).
Determining Stock Valuations
There are many ways that investors can try to determine whether a stock is overvalued or undervalued. Knowing the current price is easy – it's the amount for which the stock is currently selling. The challenge is in determining a stock's intrinsic worth.
To determine the intrinsic worth of a stock, expert investors look at the company's financial records in order to try to determine how profitable the company is likely to be in the future. One popular way to analyze the earnings potential for a stock is using P/E ratios.
What Are P/E Ratios?
Price-earnings ratios, known as P/E ratios, tell investors how much they have to invest in order to earn money from a specific stock. "P" represents the price, or the amount for which the stock is currently selling. "E" represents the per-share earnings, or how many dollars an investor can expect to earn on each share of stock in the company. This is calculated using the earnings per share from the last four quarters that the stock has been traded.
Using P/E ratios, investors can calculate how much they will need to invest for each dollar of return. A low P/E ratio can indicate that a stock is currently undervalued. On the other hand, a high P/E ratio means that investors are expecting high earnings, which can often lead to a stock being overvalued.
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- Forbes: Whitman Sampler of Value Stocks
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