2. The stock market sets up the price.
3. Analysts decide upon the value of a company based on the potential for its growth.
4. Price and value may not be equal, due to certain irrationalities governing the market.
Value investors need to rely on certain stringent rules governing the nature of the stock which adhere to the following criteria:
1. Earnings: company earnings are profits after taxes and interests.
2. Earnings per share (EPS): the amount of recorded income (on per share basis) available to the company to pay dividends to stockholders, or to reinvest in itself.
3. Price/Earnings Ratios (P/E) ratio (having a justified upper limit): If the company's stock is trading at $80 and its EPS is $8 per share, it has a multiple, or P/E of 10. This means that investors could expect a 10% cash flow return:
$8/$80 = 1/10 = 1/(PE) = 0.10 = 10%
If it's making $4 per share, it has a multiple of 20 (20 times $4 equals $80). In this case, an investor might receive a 5% return (in the same conditions);
$4/$80 = 1/20 = 1/(P/E) = 0.05 = 5%
However, a low P/E is not an untainted value indicator.
4. Price/Sales Ratio (PSR): is the same as a P/E ratio, except that the stocks are divided by sales per share instead of earnings per share.
5. Debt Ratio: percentage of debt a company has relative to the shareholder equity.
6. Dividend yields above a certain absolute limit.
7. Book value ratio: comparison of the market price against the book value of the stock per share.
8. Market capitalization value: Complete total value of a company?s outstanding shares (Market price per share ´ Total number of shares outstanding).
9. Equity Returns - ROE: Net income after taxes divided by owner?s equity.
10. Beta: comparison of volatility of the stock to that of the market.
11. Institutional ownership: percentage of a firm?s outstanding shares owned by certain institutions: insurance companies, mutual funds etc.
Learning to analyze one?s stocks and thus reaping the desirable profit is in fact a continuous process, as no amount of market efficient theories can ever predict a flawless financial return system. Even though one invests judiciously by studying the market, the over-valuation or under-valuation of stocks can often be determined by market emotions.