By: DanielXX To me, understanding valuation, or why the stock is priced the way it is over an extended period, is one of the, if not THE, key risk management method for the stock investor/trader. This is as opposed to the approach of many traders who use technical analysis, momentum trading, cut-loss etc. Indeed, if I may generalise, the upside gains from an investment comes from astute understanding of business dynamics and growth potential, but management of downside risk comes from understanding of the valuation. There are several issues on valuation that I'll discuss here. First of all, understanding what type of valuation technique drives the price of a stock is winning half the battle. The favourite technique is PE (price earnings) but I am incredulous when people quote PE for companies which should more accurately be valued by their balance sheet assets eg. property stocks. PE is more relevant for companies which enjoy steady and sustainable growth in their core earnings because it is predicated on projecting a certain level of earnings growth into the future, and hence it's imperative that these earnings are predictable. Indeed, it's worth noting that often the best time to buy cyclical companies is when their PEs are high or even negative, because it will be at the bottom of the business cycle when this happens (ie. the market-timer can catch it at its bottom). It's also interesting to observe how valuation technique can change at different points in the market cycle. In an up market, PE is often used because earnings are seen to be on a steady growth trend in the foreseeable future. Read more...