Knowing when to buy stocks

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The following article is part of an ongoing educational series. The previous article can be found here.

Imagine that you've applied your toolbox of strategies to a number of companies, and found one or two that appear to fit the bill.

They're in attractive industries, have solid core businesses, good track records, sound management, strong earnings growth, and the outlook for earnings growth to be maintained is reasonably positive.

In fact, so good is the overall picture that you're starting to ask the big question: Should I buy? And of course the answer is not an answer at all, but another question: How much does it cost?

Finding great companies and great investments is not the same thing. If years of expected future earnings growth has already pushed a company's share price to very high levels relative to other stocks, you may have to look elsewhere.

Fortunately, there's no shortage of independent research and brokers' reports to help you work out how much is too much to pay.

But while these are a useful way to get a feel for a rough price target, the fact these reports are printed in black and white draws some investors into affording them a legitimacy they don't always deserve.

No-one can truly say what a stock is "worth" - the ultimate judge is "Mr Market," given enough time - and plenty of analysts around town have egg on their faces from recommendations that have been way off.

In the textbooks, the value of a company is the net present value of its future free cash flows (this means cash that is not required to be invested back into the business). This basically means that a company is theoretically worth all of its future profits added up, expressed in today's dollars.

An investor's job is to identify a price at which the company's earnings will produce an acceptable return on investment.

If a company continues to generate earnings and produce acceptable "internal returns," this should eventually be recognised by the share market (although it may take some time), and the share price will rise - as will dividend payments, unless the company prefers to reward shareholders through a share buyback.