If you want to make a profit then you only need to follow one rule:
'Buy low and sell high.'
Simple right?
The problem is, most people tend to do the opposite. They tend to buy when the market is reaching all time highs and when things are looking expensive.
They then sell when everyone is panicking and the market is close to the lowest point in years.
If only we could turn this cycle around and 'buy low, sell high'.
I'm a big fan of being a bargain hunter. After all, half of the profits you make aren't based on just the exit price but also the price at which you bought the asset.
If you buy the asset at a cheap price, it will be easier to make a profit.
So when it comes to the sharemarket, how can you tell if something is looking expensive or cheap? How do you know if something is low or high?
The problem with the sharemarket is that things aren't always what they seem.
A $10 share is not necessarily cheaper than a $1 share.
Think of it like this: If you took that $10 share and did a share split so that the $10 share was divided into 20 pieces and each share was now worth 50c, would that mean that the new 50c share is cheaper when you compare it against that other $1 share?
The point is – it doesn't make sense to compare price like this on the sharemarket. Share price alone cannot tell you if a share is expensive or cheap.
So if you want to 'buy low and sell high' then you can't do it depending on just share prices.
If you want to get a true gauge of value, then you need to use another measure. The measure that the sharemarket uses is the price to earnings ratio (P/E ratio).
It's calculated by taking the share price and dividing by the earnings per share.
Here's a graph of the P/E ratio for the Australian market measured by the All Ordinaries index from 1980–2009.
You can see that based on P/E ratios, the market hasn't seen these types of levels since the early 1980s.
The P/E ratio is the most popular valuation tool used by investors but unfortunately it has its downfalls. That's why you should do your homework to find out what drives the business as well.
To 'buy low and sell high' you need to figure out what point is low and what point is high. The most popular way is through a valuation ratio such as the P/E ratio.
But there are other value ratios out there as well so don't feel limited to just one.
My personal favourite is the price earnings growth (PEG) ratio.
A P/E ratio is useful but it isn't the be all and end all, instead it's just one of the things to use when trying to figure out whether you are going to buy a business.
After all the sharemarket is simply a market full of businesses – some great ones, some useless ones and some hoping to be the next big thing.
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Happy trading!
Julia Lee Equities Analyst Bell Direct
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