How to know a stock is at a fair value?

6 signs of an economic rebound

To get a read on business sentiment, Behravesh suggests looking at the Institute for Supply Management's nonmanufacturing index, a monthly survey of conditions in the service sector, which accounts for 80% of jobs. A reading below 50 is typically regarded as a recession signal; the lower it goes and the longer it stays down, the more severe the slump. Once it returns to 50-plus territory, a rebound is likely.

During the brief recession of 2001, the index dropped below 50 just as the slowdown started and hovered between 45 and 50 for most of the next eight months. A month before the recession ended, the index rose sharply to just under 50 and soon stabilized in the low 50s.

For a second opinion: Look to the real estate market. "Housing is what got us into this recession," says Gus Faucher, director of macroeconomics at Moody's Economy.com. "In terms of what's going to get us out of it, we're going to be looking for a bottom in the housing market."

How do you spot that? Brush up on supply and demand. Historically, the inventory of homes on the market - particularly how many months it would take to sell it off - has soundly predicted home prices. Six months of inventory appears to be the sweet spot. In 1996 inventory fell below six months and dropped for much of the decade - and prices climbed steadily.

What they're saying now: A mixed outlook. For March the ISM nonmanufacturing index stood at 49.6 - up from the precipitous drop to 44.6 in January but still below 50 for the third straight month.

"If the index goes to 40 and stays there, we're looking at a much deeper recession," says Behravesh. "If the number goes back up to 50 and remains at those levels, that's definitely a signal that things are going to get better." Housing inventory, however, has recently hit nearly 10 months' worth - bad news for prices and growth.

To keep track: The ISM nonmanufacturing index is released on the third business day of every month. It's widely reported in the press; or you can find the releases in the ISM Report on Business section of the Institute for Supply Management's Web site.

As for the real estate inventory yardstick, the National Association of Realtors puts out the data monthly (usually between the 22nd and 25th). Look in the Research section on its Web site.

The wild cards: As Federal Reserve governor Kevin Warsh recently quipped: "If you've seen one financial crisis, you've seen one financial crisis." Indeed, this slowdown has seen a massive credit crunch, a free-falling dollar and record oil prices. At the same time, exports to China and India are helping U.S. businesses offset weakness at home. Any or all of these factors could cloud the rebound picture.

STI Head and Shoulder - 200508

Price to Book ratio and PE ratio

My rule of thumb for P/B ratio is:

• P/B less than 2 implies chances of undervaluation
  
• P/B between 2 and 3 indicates possible fair valuation
• P/B more than 3 probably indicates over valuation, anything above 5 possibly means grossly overvalued
  

My rule of thumb for P/E ratio is:

• P/E less than 10 implies chances of undervaluation
  
• P/E between 10 and 20 indicates possible fair valuation
• P/B more than 20 probably indicates over valuation, anything above 50 possibly means grossly overvalued

The Little Books That Builds Wealth by Pat Dorsey

Chapt 12 - What is a moat worth?
Even the best company will hurt your portfolio if you pay too much for it

Bottom line
1. A company's value is equal to all the cash it will generate in the future.That's it.

2. The fourth most important factor that affect the valuation of any company are how much cash it will generate(growth), the certainty attached to those estimated cash flows(risk), the amount of investment needed to run the business(return on capital), and the amount of time the compnay can keep competitors at bay(economic moat).

3. Buying stocks with low valuations helps insulate you from the market's whims, because it ties your future investment returns more tightly to the financial performance of the company.

Chapt - 13
Tools for valuation - How to find stocks on sale

The bottom line
1. The price-to-sales ratio is most useful for companies that are temporily unprofitable or are posting lower profit margins than they could.If a company with the potential for better margins has a very low price-to-sales ratio, you might have a cheap stock in your sights.

2. The price-to-book ratio is most useful for financial services firms, because the book vaule of these companies more closely reflects the actual tangible value of their business.Be wary of extremely low price-to-book ratios, because they can indicate that the book vaule may be questionable.

3. Always be aware of which "E" is being used for a P/E ratio, because forecasts don't always come true. The best "E" to use is your own: Look at how the company has performed in good times and bad, think about whether the future will be a lot better or worse than the past, and come up with your own estimate of how much the company could earn in an average year.

4. Ratio of price to cash flow can help you spot companies that spit out lots of cash relative to earnings.It is best for companies that get cash up front, but it can overstate profitability for companies with lots of hard assets that depreciate and will need to be replaced someday.

5. Yield-based valuations are useful because you can compare the results directly with alternative investments, like bonds.

Lesson from Sub-prime crisis

From Richard Scully NCR Research 04-Apr 08
1. First sign of trouble, hit the door
2. For current stock pick, look for stock that has dropped 50 to 70 % from previous high.
3. Look for stock with single PE.
4. Look for stock that is cash rich.

Lead From Warren Buffet and Peter Lynch

Stock Pick 2008