Stocks have given investors the best returns over the long run, more than any other asset class. Equities represent an important component in managing and accumulating wealth. Different stock picking strategies have been used to harness the wealth inherent in investing in stocks. The most popular strategies include value, growth, and income (dividend).

Stocks, as with all other assets, are priced based on their future discounted income or cash-flow. The higher the income/cash flow and the lower the discount rate, the higher the price of a stock under normal circumstances. However, the price of a stock is not equal to its value, and the value of a stock is more important than its price to most investors.

A common way of valuing a firm is by means of relative valuation. This approach looks at a firm’s value, in relation to its competitors as a means to determine if the company is undervalued or overvalued. Some key ratios that are usually compared are company’s Price to earnings (P/E), Price to sales (P/S) and Price to book value (P/BV). A P/E ratio of 10 means that the stock is trading at 10 times earnings, and a P/S of two means that the stock is trading at two times sales. This is also the same for P/B and other price related valuation ratios. The relative value of a stock can be calculated my multiplying the industry P/E by the company’s normalized earnings. This will give you the estimated price of what the stock is worth based on relative valuation. If the relative value calculated is greater than the current price of the stock, the security is considered undervalued.

The P/E ratio is the most popularly used stock valuation metric and the following stocks are all highly priced based on their P/E ratios – Facebook, Amazon, LinkedIn, Adobe, Netflix and Starbucks. The P/E ratios of these companies are all in excess of 100. Value investors will generally shun these stocks for other firms with P/Es less than 10, but for growth investors these stocks represent real investment opportunities.

While value stocks have outperformed growth over time, short term returns from growth stocks can be mind boggling. Amazon’s share price has increased in value by 97 per cent and Netflix by 310 per cent over the past two years. These returns are driven by high growth in revenue and earnings. Any investor would clearly see the benefits of investing in similar stocks to gain such impressive returns, but not all would want to be exposed to the risk.

To own stocks of some of the fastest-growing companies, investors will have to accept a fairly high P/E. The higher the P/E the greater the chance of a dramatic decline in the stock price if the company’s earnings and revenue stop growing in line with expectations.

Investors will have to pay a premium for fast growing companies, but they have to be careful to not pay too much. As share prices may tumble due to lofty P/E valuations, while earnings and revenues still continues to grow.

Gladstone Wynter is manager, financial planning, at Stocks & Securities Ltd. Contact: GWynter@sslinvest.com