This is an explanation of how the VectorVest system calculates the value of a company.
(For other ways of valuation, see:
Warren Buffet's 1981 Formula for quick valuation )
The P/E ratio is a common and simple ratio used to estimate the value of shares. It can be used to compare with P/E ratio of different companies in the same sector to see if the share is overprice or underprice. However, the PE ratio is very inaccurate as many stock analyst would know, but still uses from time to time.
The other funny result from P/E ratio is that for companies with No Earnings or making a loss, then the P/E ratio is infinite, hence not published. A better way is to look at the E/P ratio, for companies with no earnings, then the E/P ratio is zero.
Another quantity is the Earnings Yield, calculated like:
EY = 100 x P/E
but we can use the E/P ratio in there like:
EY = 100 / (E/P)
The E/P ratio is more intuitive because it is like Dividend / Price which is the Dividend yield, since earnings is like dividend.
Another very important relation that the VectorVest founder discovered is like investors will invest in bonds when stocks are performing poorly and then return to stocks when they perform better. So investments cycle back and forth between bonds and stocks. In the overall picture the yield from both are the same. Bonds yield are determined by interest rates (IY), so
EY = IY
Now using the previous equations for Earnings Yield (EY), we have
100 * (E/P) = IY
To find the actual value of the company, instead of price, we use the Value variable (V)
100 * (E/V) = IY
So the value of a company is:
V = 100 * (E / IY)
This gives a value of a stock such that if we assume we want to get at least the interest rate of fixed bonds, then this formula tells us the value or price to pay. So if the price of the stock is much lower than V, then it is undervalued.
Here are a few useful strategies:
- Look for Green light
- RT 15 SMA > RT 10 SMA
- VST Mighty Mites
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