Market Beat: Stock market valuations
Diversification is one of the best risk management tools that investors have available. Two of the major styles of investing are known as growth and value. Most investors should have some exposure to both.
We’re in an environment where growth stocks have been performing well and the market is also valued higher than normal. The current forward PE or price to earnings ratio is 18.8, which is above both the five-year and the 10-year average.
Over the last year as of Feb. 7, the S&P 500 Growth Index has returned 29.07%, while the S&P 500 Value Index has returned 21.44%.
The difference between growth and value is pretty simple. Growth stocks are relatively expensive but have the potential for strong growth in the future. Value stocks are relatively inexpensive, so that makes them a good deal, but they are trading at a good valuation for a reason.
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There are some common measurements that analysts use to determine the valuation of a stock. S&P Indices uses these to determine the components of their Growth and Value indexes. One is the price to earnings ratio as mentioned above. The PE is determined by dividing the stock’s price by its earnings. The ratio will be low for a value stock and high for a growth stock. Good growth stocks can have very high PE ratios and sometimes even negative earnings but have future growth potential.
Price to book value is another widely used metric. It is calculated by dividing the price of a stock by the book value of a company. Value stocks will have a low ratio and growth stocks will be higher. The book value is the amount that a company would be worth if all of its assets were liquidated and converted to cash.
Price to sales is another one and is calculated by dividing the stock’s price by its sales. Companies that have strong sales growth can appear to be very expensive today, but if the sales are growing and the company has pricing power, that can lead to good long-term results.
There are many other metrics that are used as well. Some that I like to consider are the price to cash flow and the price to free cash flow. The free cash flow is the money that is not needed for obligations. Most investors should have exposure to both growth and value in their portfolios.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://iwcasset.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.
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