How to Find Winning Shares to Buy

A few days ago, I wrote about the act of valuing businesses, and why it can help you.

Let’s build off that topic, and talk about how valuation may help you in investing. Today, I would like to sound off on three possible ways that the act of valuing companies or businesses may be helpful.

Without further ado, let’s press on.

When to buy

Price is what you pay, and value is what you get. While the stock market shows the share price of a company, it says very little about the value of the business behind the company’s ticker.

This is where the act of valuing a business may help you. If you are able to come up with reasonable estimates of the value of a business, you may – in turn – figure out what would be a good price to pay for it. And with that, you can figure out when to buy a stock.

The historical price to earnings ratio could be one way to look at the relative value of a company. We can use the example of Dairy Farm International Holdings Ltd (SGX: D01).

Here’s a chart of the retailer’s price to earnings ratio that my Foolish colleague Ser Jing had produced last week:

Dairy Farm's price-to-earnings (PE) ratio from January 2005 to 25 March 2015

Source: S&P Capital IQ

With reference to the chart, Ser Jing also noted:

“At its current price, Dairy Farm has a trailing price-to-earnings (PE) ratio of 24.5. As you can see in the chart above, that’s just about in-line with the retailer’s own historical average PE of 25.4 from the start of 2005 to today [25 March 2015].”

Margin of safety

When we make an estimate on the value of a company, the positive gap between its share price and your own estimate(s) could represent a margin of safety on the investment.

The margin of safety is important as its presence can help lessen the chances of us losing our capital.

We can use Hongkong Land Holdings Limited (SGX: H78) as an example. The company is an owner of prime investment properties located in Hong Kong and Singapore. As such, the price-to-book value (PB) ratio could provide a proxy to the real value of the company.

As of last Friday, the PB ratio for Hongkong Land was 0.63, meaning to say that the company’s share price is merely 63% of its reported book value. In this case, the gap between the current book value of Hongkong Land and its share price may make up the margin of safety for this company

How much you want to own: Allocation

The act of valuing companies can also support your decision in sizing the appropriate level of allocation for a company in your share portfolio.

We can use the high-flying software maker Silverlake Axis Ltd (SGX: 5CP) and the stodgier aircraft engineering outfit SIA Engineering Company Limited (SGX: S59) as examples to illustrate this point.

Both companies have different investment merits. If you are interested in both, then the act of valuing both companies could help facilitate your decision on how much of each you would like to have in your portfolio, keeping in mind that highly-valued shares may be riskier.

Foolish takeaway

None of the above is to say that you should run off and buy all the four companies now. After all, the value of a company is only as good as your assumptions which go into it.

Valuation is, at the end of the day, part art and part science.

To value a company is to put in your best guess of where the current business stands, and where it might go in the future. As you gain more experience and use valuation more often, you may eventually gain an advantage in finding the next winning stock.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong owns shares in Dairy Farm.