Four (4) Simple Rules To Pick the Best Stocks!

Whether or not a stock is likely to move up is essential to determining what, if any option strategies can be implemented utilizing it as the underlying stock.

Here are some of the criteria which may help you when making a decision whether or not you are selecting the stocks that have strong potential for increasing in value. It may not be possible to find many stocks which satisfy all of the following requirements. If you can satisfy 3 of the following 4 requisites, it may be worth giving some additional consideration.

1. Price of the stock divided by the book value should be less than 1

Book value is the difference between values of assets and liabilities. Book value (BV) is the theoretical value of any share of stock. Simply put, if a company were to cease operations, sell all of its assets, and pay all of its liabilities, the amount remaining divided by the number of shares outstanding is the “book value”. If we take the speculation out of the market, every stock should be trading at its bookvalue. Both price and BV ratio measure amount paid for the shareholders equity.

The lower the ratio of the stock price, to its book value, the greater the desirability of the stock. Although this calculation is readily available for stocks on most financial websites, you may calculate in this manner:

Price / Book ratio = (shares outstanding x market price of share) / (book value of assets minus liabilities).

This ratio is best used for companies that have significant assets. However, it can also be a valuable tool with smaller companies as well. Computing this ratio is simple and it is easy to understand. This provides quick view at how the market is valuing the company’s assets and its earnings. This ratio is not influenced by accounting rules and hence the price to book value ratio works around the world.

However, the asset values are calculated using their purchase price, not the current market value. Hence the ratio may not give a precise measure. This ratio may be skewed somewhat for companies that rely on intellectual property. There is the chance that we may see an artificial lower P/B ratio when an acquisition takes place. Any recent write-offs will result in the reduction of the book value of equity.

2. P/E of the stock should be less than 70.

P/E is the ratio of the current price of the stock to the earnings of the last year. The higher this ratio is, more you are paying for the stock compared to its earnings.

P/E = Stock price / Earnings per Share.

It is used to determine how expensive or undervalued a stock may be against its earnings. The ratio gives an idea of the willingness of the market to pay for the company’s earnings. Investors utilize this ratio to estimate if the stock is overvalued or undervalued. A lower P/E ratio may indicate that the stock is undervalued relative to its current earnings. Some companies trade at higher P/E ratio when they are expected to grow exceptionally in the coming months or years. Sometimes a stock with a high P/E ratio can be a good investment, as the earnings may “catch up” to the price. Often times however, this does not occur. P/Es often can be inflated during market bubbles.

3. P/E/G of the stock should be less than 1.

This is a comparison of a company’s Price/Earnings ratio to its earnings per share (EPS) Growth. If we take speculation out of the market, P/E/G should be equal to 1. This would then verify that the company is “fairly valued”. If P/E/G is less than 1, it means that the stock price is undervalued or that the company’s future EPS growth will be lower than the market estimates. If it is greater than 1, it may mean that the stock is overvalued. The stocks with value tend to have P/E/G less than 1.Many financial websites will also provide this ratio. However, it is calculated as follows:

PEG Ratio = (Stock Price / Earnings per share) / Projected annual earnings growth.

This ratio was developed to overcome the shortcomings in the usage of P/E ratio. The ratio is used to identify the undervalued or overvalued stocks using PEG ratios. Companies in different industries can have very different P/E ratios, but still be within an acceptable range. The P/E/G ratio provides a method to compare two companies to see which stock is the better investment.

The PEG ratio tends to work best with growth companies. This ratio figure is a rule of thumb, but by no means is it absolute. This ratio does not take inflation into account and it would be meaningless calculating PEG ratio if the rate of inflation is equal to that of growth rate. This ratio can be used as a supplement to other methods in order to come to a better conclusion.

4. Percentage of EPSG should be greater than 5 percent.

EPSG is the Earnings per share growth of the company. It is expressed as a percentage, and it symbolizes the expected earnings growth of the stock from one year to the next. The greater this percentage is more desirable the stock is.

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This article has been taken from the book, “Stock Options – Work 1/2 Hour A Day” and was taken as a courtesy from Poweroptions.com.

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