The #1 Rule Every New Stock Investor Needs to Know

By Tina Orem
September 22, 2011

The world of investing is large, complex, and intimidating. But many of those convoluted formulas and bewildering strategies boil down to a just a handful of simple ideas.

So if you're new to the game and are worrying that you'll never figure out finance, take a deep breath and start with this one rule first: The return you can expect from buying a stock depends entirely on whether the stock is fairly priced, overpriced, or underpriced when you buy it.

Look at it the way you look at your favorite brand of laundry detergent. It's soap. And a bottle of it is going to wash 28 loads of clothes every time. So when that $3.99 bottle of detergent gets marked up to $7.99, you know the detergent is overpriced and you're not going to buy it. In fact, you'll probably snicker at the poor sucker ahead of you in the checkout line who has two bottles of it in his basket. After all, who wants to pay twice as much to wash the same 28 loads, right? What's wrong with that guy?

Likewise, if the detergent goes on sale for $0.99, you're going to scoop it up. It's a bargain now because it costs a lot less but still has the same intrinsic value: 28 loads of clean clothes.

The same idea applies to stocks: their prices don't always equal their real "worth." And when you can pick up a stock on sale and then turn around and sell it for full price later, well, that's when you maybe stop clipping detergent coupons and start shopping for new Manolos.

This is also why the talking heads on the cable shows are always blathering on about "price multiples" -- they're using them to make a case for why they think a stock is overpriced or on sale.

There are four primary price multiples involved in these discussions: the price-to-earnings ratio (P/E), the price-to-book ratio (P/B), the price-to-sales ratio (P/S), and the price-to-cash flow ratio (P/CF). Basically, these ratios help you determine whether prices are above or below where they "should be" or "normally are," and whether stock prices are too expensive, too cheap, or just right.

The Price-to-Earnings Ratio

The most famous of the four ratios, the P/E ratio is little more than the stock price divided by the company's earnings per share (EPS) for the year. Sometimes analysts use the last 12 months of earnings, sometimes they use the last fiscal year of earnings, and sometimes they use the forecasted future (or "forward") earnings per share.

The idea is to compare the price of the stock with the profits that the company generates per share and then compare that to historical averages. High P/E ratios often indicate that a stock is overpriced; low P/E ratios can mean a bargain is in the works.

The Price-to-Book Ratio

The price-to-book ratio is simply the stock price divided by the book value of the company's assets per share. The formula looks like this:

P/B = Price per share / ((Shareholders' equity - intangible assets) / shares outstanding)

The idea here is to look at the stock's price relative to the actual value of its cold, hard assets. This ratio is especially exciting if you use it to discover that the market value of company is less than the value of its actual assets. If you're so lucky to find such a company, it means you are theoretically able to buy the company's stocks, sell all the assets, and make a profit.

Low P/B ratios imply that a company's stock is undervalued (or the company is mismanaged!). High P/B ratios suggest that the stock is overvalued or that the company is expected to create significant value from its asset base soon. This is why the P/B ratio is one way to classify stocks into "growth" (those with high P/B ratios) and "value" (those with low P/B ratios) categories.

The Price-to-Sales Ratio

The price-to-sales ratio is just the company's stock price divided by its sales per share. The formula is:

Price-to-Sales Ratio = Price per Share / Revenue per Share

This ratio is especially handy when a company has no earnings (meaning you don't have anything to calculate a P/E ratio with). Accordingly, the price-to-sales ratio is another way to determine whether a stock is expensive or cheap relative to similar stocks.

In general, price-to-sales ratios below 1.0 are buying opportunities, especially if it looks like the market has penalized the firm for what may be just a temporary performance setback.

The Price-to-Cash Flow Ratio

The price-to-cash-flow ratio is simply the company's stock price divided by cash flow per share, like this:

Price to Cash Flow = Price per share / (Cash flow/shares outstanding)

This is one of the talking heads' favorite ratios, because it only focuses on the actual cash a company generates (the other ratios are rife with accounting conventions that include noncash items). Investors often hunt for companies that have high or improving cash flow but low share prices -- the disparity often means the share price will soon increase. Thus, the lower the ratio, the "cheaper" the stock is.

Finding the Deals

Though these ratios are the bread and butter of deal-hunting, there of course is no one way to find a bargain in the stock world. The ratios do have their limitations, after all. Accounting rules can muddy the numbers, for instance, and companies in different industries have different norms for performance.

The Investing Answer: The next time you're puzzled by the pundits, remember that they're all probably talking about the same simple ideas: finding a good stock on sale means more profits for you later. Overpaying for a good stock means less profit for you later. And never underestimate the value of clean laundry.

P.S.: Speaking of finding the best deals, my colleague Elliott Gue recently put together a special report on 17 little-known "spin-off" companies. Because of the way they were formed, these companies have beat the market 7-to-1 in the past decade and raised dividends as much as 600%, yet most investors don’t understand them at all. To get the names and tickers of some of these stocks immediately, click here.