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Follow These Four Investing Rules to Profits

Paying close attention to the fundamentals can help you find stocks that are undervalued and know when they've gotten ahead of themselves, Real Money Columnist Paul Price says.
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Investing is an art as much as a science.

While charts and numbers help enormously, if you could break this down entirely to a numbers game everyone would be a millionaire. (And to be fair, if you just play the numbers and sink your money into an S&P 500 index fund, you will probably do quite well over time. But that’s “retire comfortably” money, not “bored with the color of my yacht” cash.)

To help with your thinking, Real Money Columnist Paul Price recently outlined four guidelines he uses to make better investing decisions.

"I don't go by what I think the shares deserve to sell for. I don't compare the stock's valuation to other industry players," Price wrote recently on Real Money. "For me, long-term average valuations on that same stock are the best guides to what can be expected over time, due to reversion to the mean."

Price laid out his four rules of thumb this way.

1. Avoid paying more than a stock’s own average price-to-earnings

A high price-to-earnings (P/E) ratio indicates that the market has a lot of confidence in this stock. As P/E goes up, it means that share prices have increased relative to the underlying company’s revenues. The problem is that, as P/E rises, it also means that the company’s stock might have become increasingly disconnected from its performance.

Ideally, you want to buy for low P/E ratios and sell when P/E gets particularly high. This is doubly true if you can buy when the stock’s price has fallen below its P/E ratio.

2. Try to buy when the stock’s current yield is higher than its own average level

Yield means the payment that individual investors receive, generally in the form of dividends. Buying in during a high-yield period will increase your gains, since you’ll make more money while you hold the stock as well as when you sell it.

3. Sell whenever the shares fetch higher than typical multiples

Multiples are a general term that means comparing different aspects of a stock’s performance. Usually, investors use “multiples” to refer to a stock’s P/E ratio. A price-to-earnings ratio measures the stock’s price as a multiple of its earnings. (Literally, a P/E ratio of “10x” means that the stock’s price is 10 times the company’s earnings per share.)

Regardless of which metrics you’re analyzing, high multiples often indicate high performance or over-performance. That’s particularly true when it comes to P/E ratios. The higher your multiples are compared with the stock’s baseline, the more likely it is that the company has become overvalued.

4. Sell when the current yield is substantially below normal

Finally, a good time to sell a stock is when you aren’t making money by holding it.

The higher a stock’s yield, the more money you’ll make by just keeping it in your portfolio. It will continue to generate dividends while it sits there. When that yield falls, then holding the stock isn’t doing anything for you. It’s time to turn that asset into capital gains by selling it.

Get more trading strategies and investing insights from the contributors on Real Money.