There is a difference between strategies for share market investing and strategies for picking shares, and many retail investors ignore the investing strategies in favour of share picking tactics.

To develop a strategy for share market investing you start with defining your personal investment goals.  While a goal of making as much money as I can as fast as I can might appear ludicrously simplistic, if you are 25 years old with no family responsibilities and a substantial income, it might actually have some merit.

However, most of us think of goals in terms of specific returns over set time frames.  A 55 year old has different needs and a different time frame than the 25 year old.  

Asset allocation and risk tolerance are the other two cornerstones of an investment strategy.  How much can you afford to invest and how will you spread it around?  Can both your wallet and your emotions handle shares of highly volatile companies?

It is the fourth stone in the investment strategy foundation that gets the most focus – buy and sell guidelines.  Unfortunately, far too many retail investors pay attention only to the first half of the stone – the buy decision.

Share picking tactics are all about generating potential targets.  Last week we looked at Top Down Investing, using a recent macroeconomic event – the Australian flooding – to develop a list of eight potential targets.

To sort through such a target list, or watch list, to pick shares worthy of your consideration there are a variety of tactics and strategies available.  One of the most used is Ratio Analysis, sometimes called Quantitative Analysis.  While some retail investors feel they lack the business acumen needed to make sense of the huge number of financial ratios you see on financial websites, the truth is anyone can learn to use them, and even “experts” often misuse them.  

There are several broad categories of financial ratios used as metrics to evaluate various aspects of a business, such as its profitability, operating performance, cash flow, liquidity, and solvency or debt.  However, none is so near and dear to the hearts of retail investors the world over as Valuation Ratios.

Valuation Ratios have the potential to tell a retail investor whether the current share price is a good deal or a bad deal, depending on your investment outlook.  The idea is if the current share price is inexpensive relative to its performance and potential, it makes for a sounder investment.  Other investors, however, can see the same Valuation Ratio and feel the shares are too cheap to consider.

Here is our target list from last week, with three of the most used Valuation Ratios - the Price to Earnings Ratio (P/E), the Price to Book Ratio (P/B), and the Price /Earnings to Growth Ratio (PEG) - listed for each of the eight shares:

In the eyes of many in the investment world, the P/E Ratio is the mother of all ratios.  It is the Holy Grail of share picking.  The P/E is so universally beloved because it compares the price of the shares to the earnings generated by an individual share.  The P/E is calculated using readily available values.  But you will not have to crunch this ratio yourself; you will find it literally everywhere.  Here’s the formula used:

Price/Earnings (P/E) Ratio = Share Price per Share/Earnings per Share

From the table we see that HVN (Harvey Norman) has a P/E of 12.37, which means HVN is currently trading at 12.37 times the company’s basic net earnings per share.  Another way of interpreting the ratio is that the investor is paying $12.37 for every dollar of HVN earnings.

The P/E sends signals to every type of investor.  Growth investors shy away from shares with low P/E Ratios, believing the market is judging the shares as having low growth prospects.  They prefer shares with high P/E Ratios.

Value investors look for shares that are cheap and undervalued by the market. A low P/E may be a signal that the market is overlooking the true value of the stock.

Of course, investors must compare a company’s P/E Ratio against something to have true meaning.  The most common comparisons are other companies in the same industry segment and even better, close competitors.  Some investors use the P/E of the market as a whole.  Generally speaking, a P/E of over 15 is an indication a share may be overvalued.  Value investors drool over shares with P/E Ratios under 10.

However, it is all in the eye of the beholder as a growth investor may look at a P/E of 15 and think the shares are too cheap to reap maximum returns.  There is a common error made by both growth and value investors and that is stopping their homework when they see a P/E that jumps off the page at them.

Despite the fact investors are counselled time and time again not to be lured by one attractive ratio, spend some time on investment community discussion forums and you will find investors who live and die by the P/E Ratio.

Here is one example of how a P/E taken alone can be misleading.  A value investor might look at our target list and find HVN, with the lowest P/E of the three consumer retail shares listed, as a possible buy.  Taken alone, the P/E Ratio says HVN may be underpriced.

Enter stage left another valuation ratio – the Price/Earnings to Growth (PEG) Ratio.  This Ratio adds expected growth to the equation as follows:

PEG Ratio = P/E Ratio/Earnings per Share (EPS) Growth

The EPS growth number is provided by the company and is their forecast of how much additional earnings they anticipate in the coming reporting period.  Although nowhere near as widely used as the basic P/E Ratio, many financial experts feel the PEG gives a better measure of whether the share price is undervalued or overvalued.  

A PEG under 1 means the shares have the potential to beat the market’s current valuation of the shares.  High PEG Ratios are clear indications the shares are currently overvalued.  

Now look at the PEG Ratio for HVN – a whopping 6.95!

Never, ever stop your digging into a potential share buy based on a single ratio.  Next week we will look at other key valuation ratios and see how they can be used and misused.