Using Earnings Per Share to Buy a Stock.
For that, you will have to look at the predictability of the company's earnings record. Company A has consistently earned returns and it has been increasing at a steady pace. Company B has fluctuating returns albeit with bigger positive returns in certain years but with losses in some years.
| Year | Company A | Company B |
| 2005 | $0.50 | $0.75 |
| 2006 | $0.55 | ($0.20) |
| 2007 | $0.65 | $0.67 |
| 2008 | $0.72 | ($0.25) |
As you look forward and try to predict the future earnings for the next year till 5 years later, which company will you be more confident of predicting?
So the next time you see a company like A, you will be interested to dig deeper to see if the company is worth investing into as you will be able to predict the initial rate of return that you can get.
Assume that in the year 2008, you find that company A is worth investing into after detailed research. At the point that you were interesting in buying into company A, the price was $9.50. Thus, the initial rate of returns will be 7.6% (0.72/9.50=7.6% rounded to 1 decimal place).
What if the price of company A was suddenly down, as negative news affected sentiment in the industry it was in and the price of its stock became $9.00? At this price point, the initial rate of returns becomes 8% (0.72/9.00=8%). And imagine if you can extrapolate this 8% and more growth into the next few years.
Thus, for us as investors, the key crucial point become whether EPS of the company has a predictable pattern which you can confidently predict for at least 5 years ahead. Then the next point will be at what price you buy into the company at.
If you are interested to know more, you can read Mary Buffett and David Clark's book, Buffettology, which gives a very clear methodology to how Warren Buffett goes about looking at companies and analyses them.
Therefore, there is a very calculative methodology to why Warren Buffett is buying into companies when there is a recession going on. His initial rate of returns becomes high when the companies he buys into has consistent positive EPS despite depressed prices.
He just bought into another company, Becton Dickinson. Do yourself a favor and look into it if you have spare cash for investment.
How to choose a stock to buy?
So you have set aside at least 3 months worth of your salary as savings for use in emergencies. With the remaining sum of money, you want to use it for investment. What are the things to take note of when buying a stock?Is the market too high to invest in right now?
This brings us to the third thing one should look at when deciding if the market is not worth investing- the P/E ratio of the markets. This is the Price over Earnings ratio that investors commonly use in their decision making on which stock to buy or sell. This ratio can also be used as an indicator for you to estimate the time for you to start buying or selling your investments. As the chart above, from Ticker Sense, indicate, if you had know the P/E ratio at 1999 was above 30, you would be very worried and had trimmed your holdings. If you did so, you would have escaped the biggest meltdown in market history, a combination of tech bubble bursting, the 911, SARS etc. Then when you have seen in 2003 that the P/E ratio had gone to the low 20s and below, you would have started your investments into the equities market again. At this moment, the P/E ratio is around 20. So do you still think that the prices of the markets are too high?
A sad thing that is always seen is when many ordinary investors stay away from the markets because they perceive the market to be at a high price and stay away when other investors stay invested and go on to reap a high return as the markets moves further up. Then the investors who had not invested goes into panic and starts to invest at near the peak and is left holding the can when it drops and savvy investors pull out of the markets.
