How to Determine When to Invest in the Stock Market

Updated on December 23, 2018
Believe in USA profile image

I've been investing since I was 16 and have accumulated over 20 years of independent investing experience.

Buy for a little and sell for a lot

The old adage in business says you need to buy for a little and sell for a lot. Surprisingly, many do not abide by this principle. Time and time again you people pile into high flying stocks only to pull their money out when these stocks start to lose their luster.

In order to make money in stocks you need to buy when prices are low. Famed investors like Warren Buffet are famous for saying that you need to "buy when there is blood in the streets.” But how do you know when it’s actually a good time to buy? This article will describe techniques you can employee to help determine a good time to buy a stock.

In this article I will be using data from an actual stock that I own however I will not be revealing the name.

Price to earnings ratio

The price to earnings ratio (P/E ratio) is the ratio of the price of a company's stock to its earnings per share. It is a measure of how much a company is valued compared to how much money it earns. If a company has a high P/E ratio it means that it has a very high stock price compared to the amount of money it actually makes. A low P/E ratio means that a stock has a low stock price compared to the amount of money it makes. A low P/E ratio can indicate an undervalued stock that you may consider buying however there are several things you need to take into consideration when evaluating P/E ratios.

First, not all P/E ratios are created equal. Historically, investors are willing to pay more for fast growing companies than for more established, slower growing organizations. They are willing to tolerate higher P/E ratios in fast growing companies because, if the company keeps growing rapidly, its P/E ratio will contract as it makes more money.

A good way to use a P/E ratio is to compare a stock's current P/E ratio to its historical P/E ratio and that of its sector index. Morningstar is a great site to get this information. For example, let's say you were interested in buying a technology stock that we'll call stock T. You could go to Morningstar.com or whichever site you choose and look at the stock's P/E chart. In the chart below you will see that the P/E ratio for stock T historically hovers around 23 but is currently 19.

A sector index is a group of similar companies. For example the technology sector consists of technology companies while the health care sector is made up of drug makers and hospitals and other healthcare related companies. Since stock T is a technology company it should be compared to the S&P Technology Index. To find this go to Morningstar and search for the SPDR Technology ETF. The SPDR ETFs are low cost ETFs that mirror the common indexes and provide a quick and easy way to examine a sector. When you look at the P/E ratio of the SPDR Technology ETF, you will see that it is 18 which is slightly lower that stock T. Based on the P/E ratio, stock T appears slightly overvalued so an investor may want to wait until its price is lower before purchasing it.

Historical PE ratio of Stock T

10-year PE chart for Stock T
10-year PE chart for Stock T

What is a Sector Index?

A sector index is a group of stocks that represent a particular sector. For example, the financial index is made up of banks and insurance companies, whereas the healthcare index is made up of drug makers and hospitals. Some of the most common indexes are summarized in the table below.

Not all sectors are created equal. For example, the S&P technology index, has a P/E ratio of 18 while the S&P Pharmaceuticals Index has a P/E ratio of 12. While 12 is lower than 18, keep in mind that investors are willing to tolerate higher P/E ratios in fast growing companies. Technology companies tend to be faster growing than older, larger pharmaceutical companies.

A great site to find all the indexes is https://www.cnbc.com/sector-etfs/. A screen shot of that site is included below. In addition, SPDR ETFs are a great way to view financial statistics of sector indexes. Right below the screen shot of the list of indexes is a screen shot of the SPDR technology sector ETF. Notice the list of companies that comprise the ETF.

Market Indexes

Index
Type of companies represented
Financial
Banks, Insurance Companies
Industrials
Heavy equipment makers, tool manufacturers, car companies
Telecommunications
Companies that provide wireless and internet services
Energy
Oil and gas producing companies
Utilities
Electricity and Water Utility Companies
Health Care
Pharmaceutical Companies, Medical Device Makers
Consumer Staples
Snack Food Makers, Consumer Products companies
Consumer Discretionary
Restaurants,
Gold Miners
Gold mining companies
Real Estate
Home Builders, Real Estate Investment Trusts
An Index represents a specific sector of the market such as healthcare or finance. It is made up of a group of stocks that represent that sector. For example, the financial index includes bank and insurance company stocks. A great site to view the

The holdings in the SPDR Technology Sector ETF

Evaluate the company’s competitive advantage

Determining when to buy a stock involves looking at the numbers and taking a look at the business itself. For example, when evaluating whether to buy stock T, I looked at the company’s competitive advantage. This particular company was a chip maker who specialized in making chips that convert an analog signal to digital signal. This is the technology that devices like the Amazon Alexa use to convert a person’s voice to a command. In addition, stock T was focused on making analog chips for use in automobiles, a fast growing part of the business. They are the market leader in this area. The analog chip space also has a high barrier to entry so there is a low chance that a competitor could emerge out of nowhere.

Search out research opinions

There are many sites that offer research opinions on stocks. My investment advisory firm offers detailed analysis reports on stocks. They rate a stock as either a buy, hold, or sell and explain the reasons for their opinion. If you invest through an advisory firm you will have access to many expert opinions and analyses. Another good source for opinions is Morningstar. It lists what it assesses as the value of a stock on a horizontal scale. A quick glance tells you whether or not the analyst thinks the stock is undervalued and the degree to which it’s undervalued. Morningstar also offers a target price and a detailed stock analysIs. The actual Morningstar report for stock T is listed below. It lists it as being right on the border between fairly valued and undervalued.

Put it all together

Deciding when to invest in the stock market can be an overwhelming experience. While they don't address all factors, the principles described in this article provide a solid framework for determining if a stock is undervalued. In summary, if you have a stock you are thinking of buying I would recommend:

1. Examine its current price to earnings ratio and evaluate whether it is higher than the stock's historical price to earnings ratio and the price to earnings ratio of its sector.

2. Evaluate whether the company has a competitive advantage in the business or businesses in which it operates.

3. Examine stock research opinions from professional analysts.

Questions & Answers

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      • Eurofile profile image

        Liz Westwood 

        5 weeks ago from UK

        Thanks for the tip.

      • Believe in USA profile imageAUTHOR

        George Johnson 

        5 weeks ago from San Antonio, TX

        If you are nervous about buying too high than a good idea would be to do something called dollar cost averaging. In dollar cost averaging you invest a small amount of money each month. You hit the highs and lows but over time this strategy has been proven to make money over the long term.

      • Eurofile profile image

        Liz Westwood 

        6 weeks ago from UK

        My trouble would be in judging when the stocks have bottomed out.

      • Believe in USA profile imageAUTHOR

        George Johnson 

        6 weeks ago from San Antonio, TX

        When a recession is upon us there are great opportunities to invest in the stock market. During the great recession from 2008 to 2008 the American S&P 500 index decreased over 50% and the British FTSE decreased over 60%. The S&P 500 has more than tripled and the FTSE is up over 50%.

      • Eurofile profile image

        Liz Westwood 

        6 weeks ago from UK

        As a kid I used to enjoy playing a stocks and shares game. In adulthood I have been more reluctant to risk my money in stocks. What advice would you give for coping with a recession?

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