There are thousands of publicly traded companies. If you want to get into stock market investing, or if you’re looking to improve your performance in the stock market, how do you know which stocks to buy? Any one stock has dozens of indicators that each tell you a little piece of how that company is doing. Over the decades many theories of investing have been put forward in an attempt to make sense of all the stock market data that is available. One particular theory that makes a lot of sense to me is value investing, which looks for stocks that are currently trading for less than the value they should have.
The Little Book that Beats the Market, by Joel Greenblatt, attempts to make value investing extremely easy by turning certain measures of a stock’s performance into a formula. The book lays out the formula by which any investor can find good companies that are priced low. In order to find good companies, we look at the stock’s earnings. The formula lists all stocks in order of earnings, assigning a numerical rank to each one. In order to find companies that are priced low, we look at a stock’s price-to-earnings ratio. A lower ratio indicates a better bargain. The formula again lists all stocks in order of price-to-earnings ratio, assigning a numerical rank to each one. The formula then adds the two rankings of all the stocks and lists them in a master ranking. Those with the lowest ranking are the best companies at the lowest price.
There are of course, many, many other measures of a stock’s performance. And companies with star power, like Microsoft or Coca-Cola, won’t be found on this list. But sometimes having too many things to look at prevents us from taking any action at all, and narrowing our field down to earnings and price-to-earnings ratio can help to focus on the things that really matter.
This article originally appeared in the December 26, 2007 edition of the Greenhorn Valley View.