About two weeks ago, I sent an email to my subscribers asking them what they struggle with. The goal was to create one-on-one discussions with my readers. I was surprised to receive over 300 emails in the same week! Amongst the many replies, one struggle surfaced most often: How can you find the real value of a stock – especially in an overheated market like this one?

In Other Words… When Should I Buy a Stock?

Investors are not born geeks with the incredible urge to spend hours calculating the intrinsic value of companies. They don’t crave the moment they will spend their Sunday afternoon to determine if Walmart (WMT) is worth $75, $80 or $90.

What investors want is to make the right purchase at the right price. This makes sense as the less you pay for a stock, the quicker you make money with it. But in order to know when to buy a stock, the first step to do is to know how much the stock is worth.

When you think about it, it’s the same thing as buying a TV. If you know how much the new Samsung 70″ is worth, you know when it’s time to buy it on sale and you don’t need the vendor to tell. You know because you know the intrinsic value of the TV.

Unfortunately, appraising the fair value of a company is not that easy. You can’t simply run a search through internet and find 4-5 comparables at different stores to make up your mind about how much it’s worth.

A Classic and Almost Too Easy Way to Value a Stock

At first glance, you can determine how much a stock worth by looking at its P/E ratio. Note: this seems basic for most investors, but I need to start with this simple step before I go on with further explanations.

The P/E ratio stands for “Price to Earnings Ratio”. In other words; how many times will you pay for the earnings of a stock. If a company makes $1 per share and it’s traded at $15, the stock is trading at a 15 P/E ratio. The historical S&P 500 P/E ratio is around 16 to 17. This means that you usually pay 16 to 17 times the current earnings of a company. The point is to buy the stock today in the hopes it will continue to grow and that the company will make at least this amount of profit in the future.

When you see companies trading at 30 or more P/E ratio, it usually means that important growth expectations are priced into this company. Facebook (FB) which currently trades around 96 P/E ratio is a good example.

Buy triggers using the P/E ratio are pretty straightforward. By looking at the current industry P/E ratio (the company’s competitors), you will get an idea of the average P/E your stock should trade at. You can cross reference it with the historical P/E ratio of 16-17 (note that some industries are completely disconnected from the historical average and can show lower or higher P/E without telling you it’s a bargain). If all stocks are trading around 16 P/E ratio in a specific industry and the company you are looking at is trading below this valuation – there you go with your buy trigger!

Unfortunately, there are many problems associated with the usage of the P/E ratio. It can’t be that simple, right? Here are some things to keep in mind when you use the P/E ratio as a method of valuation:

#1 The way earnings are calculated can lead to confusion (exceptional profits or loss, future potential or decline in the industry, etc)

#2 When the market is down, all companies seem to be bargains (but some of them will crash and burn during the recession)

#3 When the market is up, all companies seem overpriced (but some of them will continue to find growth while others will crash and burn… again!)

#4 The P/E ratio can change drastically upon new financial results – this is a current valuation of the company not always telling you about the future.

Forget about Easy – Apply a Real Math Model to Assess Value

If you are comfortable with math and enjoy playing with numbers, there are various mathematic models used to determine the real value of a company. The point is to use the current numbers you have on hand while projecting them into the future. The most popular model to assess dividend stocks is the Dividend Discount Model. In two lines, the model calculates the current value of all future cash flows (e.g. dividend paid) generated by a company. This makes tons of sense since dividend investors want to know the current value of a company that will pay future dividends. If you want to dig into a longer explanation of the Dividend Discount Model, I suggest this article written by Matt @ Dividend Monk.

Some investors will also add the Margin of Safety concept to their calculations. The margin of safety is used to create a buffer between the intrinsic value you have calculated and the possible chance of making a mistake in your calculation. Yeah I know… we are already pretty far now in the geek world and I’ve probably lost the ambition of 80% of beginner investors by this point.

But there is more! Advanced investors use various existing models and mix them with their own theories and investing strategies. They usually combine various calculation methods and build huge excel spreadsheets that can attribute a value or a score for each method. A good example is Dividend 4 Life Pre-Screen Model. I’m not going to go into the details of his approach and I’ll let you check it out.

Calculations Take Time; But I Can’t Go Wrong with Them… Right?

Regardless the model you use to determine the value of a stock, you will always find someone that says your method ignores an important factor…. Or gives to much weight to another. But this is not the worst part.

Your calculations are as good as your guesses will be. The problem with all models is that it requires human input. It requires YOU to estimate what returns you expect, how the company should grow its cash flows in the future and how the market will react with new data. If you are using the Dividend Discount Model and expect a 5% dividend growth and the company cuts its dividend 4 years later due to an unexpected event – do you think your valuation will still stand?

I don’t want to offend anyone and here’s my opinion about stock valuation models: they are not worth my time. Since the chances of using the wrong assumptions are very good, I don’t know why I would spend hours doing all kinds of calculations for all kinds of stocks to build my portfolio. In fact, if you start using valuation models, you will have to run your calculation each time the company issues new financial results to make sure it’s not the right time sell (or even buy more!). Therefore, you will be stuck in an endless spiral of calculations. Some people like that and they are very good and successful with it. I say good for them; I’m not this kind of investor.

If I Despise All Stock Valuation Calculations – What Do I Do?

Some people find my method too simplistic or even naïve but I don’t like big calculations in a world filled with unexpected events. The economy is moving faster than a break-dancer and you expect to be able to calculate its next move? I don’t buy that.

I’ve come up with my own way of building and managing my portfolio. It includes my own way to determine if I should buy a stock or sell it. I’ve created a simple but effective way to invest. It took me years, but I’m finally happy with the way I invest and the returns I’m making.

I’ve shared most of my strategy within this blog but if you want a shortcut and save yourself hours of reading, I suggest you check out my special dividend project and register to my exclusive mailing list. I’ll be launching my project in December – so hurry up

Would you like to find the “perfect” stock at the “perfect” moment? You know the one that will not only bring in a solid dividend payout but will also show a profit over 20% within a year or two. You know these stocks exist. Just this year, I was able to catch 10 stocks (out of 20) on the US market that went up by more than 20% in my Best 2013 Dividend Stock List:

Results as at October 1^st 2013:

On the Canadian Market, I was able to catch 2 stocks (out of 10) doing over 20%:

Andrew Peller (ADW.A) at 36.63%

Black Diamond Group (BDI) at 22.28%

I guess you will claim that’s easy to pick stocks doing +20% when the S&P 500 is almost there anyways. But the key is that dividend stocks (without their dividend return) should not beat a bullish market. They are supposed to be more conservative and perform well over time since they pay dividends and they will suffer less during bearish market. But just to give you an idea, last year, my 2012 Best Dividend Stock List finished with 5 US stocks (out of 20) over 20% (STX, HRS, FLO, SXL and HAS) and 2 (out of 10) Canadian stocks (MG and CRJ.B at 19.60%). My batting average is still pretty good in a year where the S&P 500 did 11.52% and the S&P TSX did 4%.

Last week, I discussed how important your core portfolio is. This is the skeleton of your investments and how you will go through any storm. I also mentioned how boring the core portfolio is since you buy a stock and rack-up the dividend payments over several years, read until retirement! There is nothing very exciting about this even though your average investment return will make you smile 10 years from now. This is why I’m adding a few “satellite” stocks to my portfolio to make sure I have fun and can expect a sky rocketing dividend stock once in a while. How can you find dividend stocks that are ready to fly? This is a tough question to answer considering you will have to take more risk to find them as well. Based on my experience, I pulled out a few common metrics to watch for in picking one of these allstar dividend stocks that will make you look like a rockstar during Thanksgiving (Happy Thanksgiving to all Canadians, eh!)

#1 It All Starts With a Trend

If you look for a rockstar dividend stock but don’t want to risk too much, the first step is to look for companies within a trend. I remember that back in 2011-2012, several techno stocks were sitting on billions of dollars and decided to increase their dividends. Techno stocks were hot in general and many of them had a good ride on the market. I’m thinking of Intel (INTC), Seagate Technology (STX), Microsoft (MSFT) where it was relatively easy to pick them in 2011 at a low price and sell them with more than 20% profit within 12-18 months.

Early in 2013, the trend was FOOD! I actually called it right with my 2013 Best Dividend Stock List including 5 stocks related to the food industry. They don’t show a YTD return over 20% now but they were a few months after Warren Buffett bought Heinz (HNZ) and took a great dividend stock out of the public market. If you are able to identify the right trend in the right sector, picking a great dividend stocks from the list will definitely make it a rockstar in your portfolio.

#2 Find Beaten-up Stocks

Finding beaten-up stocks is definitely riskier than looking for a trend in the market. The reason is that stocks are getting beaten-up for a reason! You need to be able to see if there is any possible upside over the long haul. A good example from my current holdings is Apple (AAPL). The stock is far from being as popular as it was 2 years ago. But I believe the company will be able to show reasonable growth over time. The company is sitting on billions of dollars. It can easily buy back more shares or increase their dividend over 3% later on. These are two moves AAPL can do that will push the stock over $500. I don’t think Apple will break records as it used to do in its golden year, but I’m convinced the stock is undervalued right now that the hype is gone. This is why I’ve taken a chance with this investment.

I’ve successfully bought Johnson & Johnson (JNJ) after their recall problems and Seagate Technology (STX) after the major flood. Both stocks showed awesome profits. I’ve sold STX but I’m still holding JNJ.

However, I tried the same strategy with RIM a while ago and should have sold it when it had bounced back over $70. I held the stock thinking their next Tablet and smartphone would gain solid market share but the opposite happened. I sold my shares around $43 and took the loss. Buying beaten-up stocks is not that easy!

#3 Look For Cold Hard Cash

When a company has a lot of liquidity, there is always a chance they make a huge move with it. Moves like massive share buybacks or dividend increases year after year will catch the attention of investors. Therefore, the demand for this company will increase and you will see the stock price go up faster than the rest of the market.

Therefore, if you can find companies with high cash flow and a relatively low P/E ratio (under 15 is perfect!), you are on the right path to find a company that could become a rockstar later on. Cash is always king!

#4 Solid Growth At a Reasonable Price

When I look for a new stock to add to my portfolio, I always start with a stock screener using my metrics (described in Dividend Growth – Freedom Through Passive Income). From that list, you get stocks showing constant growth in both sales and profits along with a good habit of dividend increases. Many of these companies could be part of a core portfolio instead of the small portion of rockstar wannabes.

However, some companies show great metrics but are traded at a reasonable or ridiculously low P/E ratio. It’s very important to understand why a stock is traded at a low P/E ratio. If you just pick-up the stock because it is traded at 8 times its profit, you might be buying a dying cow instead of getting the next cash cow!

Once you have found why the value is not reflected in the stock price, you can take the decision to buy this stock and hope that you are right!

One More Thing About Buying Rockstar Dividend Stocks

While I repeat it all the time; building your core portfolio is a bit boring. However, I find it easier than finding a gem in the middle of a haystack. When you look for a rockstar dividend stocks, you look for a stock that is undervalued. With the number of investors and the amount of information we receive daily, it’s hard to find that hidden beauty. You often need to take a leap of faith in the company and hope that your expectations will be materialized over time.

The other touchy topic is to know is when to sell these rockstar stocks. Some of them skyrocket for a while and then drop back to a “normal level” once the hype is over. This is why it’s important to fix a selling price or to follow these companies closer. I dropped my shares of INTC and STX for the same reason: the hype was slowing down as their sales stagnated. Most rockstar dividend stocks won’t be held in your portfolio too long. Don’t make the mistake of falling in love with your holdings!

Chances are you will lose money on some of these stocks. The key is to be able to find a few great picks that will compensate it and boost your portfolio return.

The Key to Pick SkyRocketing Stocks

I’m currently working on an investment tool that will allow you to identify such rockstar dividend stocks while minimizing your risk. Register here to be the first to know about this awesome tool!

You probably work very hard earning your money and putting a few bucks aside. But once your savings grow, you then wonder what to do with it to make it even bigger. What’s the point of having $10,000 sitting in your ING account paying less than 2%, right? This is the moment when you start looking for an investment strategy: will you invest in stocks or bonds? Dividend or penny stocks?

What’s the best investment strategy? That all depends on your type of investor. I’ve listed a bunch of investment strategies; let me know which one is your favorite!

Dividend Investing

Well, duh! This is obviously my favorite investment strategy. Over time, I think it is one of the best investment strategies. When a company pays dividends, it is usually because it makes money. The fundamental of any investment is to make money. Therefore, selecting stocks with sustainable dividends is also selecting stocks that have a great chance of growing in the future. You can see my dividend holdings here.

Coach Potato Investing

The idea of coach potato investing is seducing: you build a passive ETF portfolio and simply rebalance it once in a while. The idea is to simply follow major indexes related to stock markets, fixed income and commodities. It doesn’t require much time and it’s quite inexpensive in terms of transaction fees. This is why it is so popular. You can’t obviously expect to beat the market since you are replicating it and still, it is a good way to invest if you don’t like reading too many financial statements. Dan Bortolotti @ Canadian Couch Potato does a good job explaining index investing.

Technical Analysis

You already know what I think of technical analysis; I’m definitely not a big fan. The main reason is that I can’t get my head around the fact that a simple graph with a few stats can dictate where the stock will go next. If the company makes money, I don’t care if there is a Hidenburg Omen, I will buy it anyway. Nonetheless, many people make money from technical analysis since they are attached to their computers for many hours and find patterns. Registering for the free INO trading course will show you how it works.

Market Neutral Strategy

This is an interesting investment strategy where you are long (buy) a stock and short (sell) another one. For example, let’s say that you think that Apple (AAPL) will to better than Microsoft (MSFT). You can short MSFT and buy AAPL with the money. We call this investment strategy “market neutral” as the goal is to benefit from both rising and decreasing stocks at the same time. You guessed right; the key in this strategy is to pick the right stock AND the right direction. Intelligent Speculator shows some of his market neutral trades on the sidebar of his blog.

Option Trading

Trading options is a great way to hedge your portfolio. For example, you can buy put options (options to sell) where you can sell your stock at the put option even if you hit a market crash and the stock drops by 20%. The call options enable the investor to buy stocks at a fixed price. This is also a good strategy when you expect the stock to go up. If it doesn’t you don’t have to buy the stock and let the option expire (each option has an expiry date). Martin @ Hello Suckers trades options within his investment strategy.

Penny Stocks

I used to play this game when I started trading. Penny stocks are fun to trade since you can buy a stock at $0.20 and it could fly up to $2.00 in no time. This is a great way to make a lot of money. The problem is that the trade could go the other side! I also bought a penny stock that kept on climbing (from $0.37 to $1.41) and rapidly (over lunch time!) fell back to $0.45.  This was the last trade I made on penny stocks. I’ve worked too hard to lose money like this!

Forex

For me, trading forex is like playing at the casino. Forex trading strategy is making money from currency variations. If you think the US dollar will go up compared to the Yen, you can make a trade based on your assumptions. There are so many things influencing currencies that I would never try to play around Forex. But that’s just me!

Growth Investing

I’ve long been a growth investor looking for companies that will burst their way to the top. I can actually classify my investing style as aggressive growth back then. Very few of my stocks were paying dividends and I used to focus on future potential. I found this trading strategy very demanding as you need to understand what the company does, where it is heading and combine it with the overall industry and economic environment. It always feels good when you pick a stock that grows by 70% within a year but it’s highly time consuming. Don’t forget that for each homerun, you will strike out at times as well!

Combine Different Investment Strategies

Many investors will decide to combine 2 or more investing strategies in their portfolio. For example, I like combining my previous aggressive growth investing style with my current dividend investing policy. Some others will build a core coach potato portfolio and add dividend stocks or options to hedge their positions. I believe the key is to build a core portfolio based on a solid investment strategy and add other stocks as a complement.

Which investment strategies do you use most? Why?