Making a smart investment in a good company will get you a high return of capital. But what is “good”? And how do you know if it is “cheap”?
For example, a highly leveraged company can have a high ROE during the boom stage of the economy, but suffer huge losses and face a high bankruptcy risk in times of economic crisis.Hence, it is preferable to use the return on invested capital where all capital contributors are taken into account, and resources not utilised in the ordinary operations such as excess cash excluded. It also excludes those one-time off items.
The biggest danger is that the firm will lose its lustre over time when the high expectations are not realised and the premium paid dissipates. Besides, different times, industries, different growth profiles, health of balance sheet etc will result in completely different PE ratios. All the above are only valuations in relative terms. The best is if one can estimate the intrinsic value of the stock well and then invest in the company with a wide margin of safety. That involves the controversial discount cash flows analysis.Why does this still work in Bursa?
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