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.