Saturday, 9 June 2012

A stock price must past 2 tests to be considered reasonable.

The most important task in buying a stock is to determine that the company is a good company, in which to own stock for the long term. 

However, no matter how good the company, if the price of its stock is too high, it's not going to be a good investment.

A stock price must pass two tests to be considered reasonable:

1.  The hypothetical total return

The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15 percent - sufficient to double its value every 5 years.

2.  The potential risk 

The potential gain should be at least 3 times the potential loss.

To complete these tests, you have to learn how to do the following:

  • Estimate future sales and earnings growth
  • Estimate future earnings
  • Analyse past PEs (check the present PE relative to its usual average PE)
  • Estimate future PEs.
  • Forecast the potential high and low prices
  • Calculate the potential return.
  • Calculate the potential risk.
  • Calculate a fair price.

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