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Momentum Trading prioritizes price movement over all other indicators and considerations, but there is absolutely no reason why a high-quality momentum trading strategy cannot contain other metrics for evaluating the attractiveness of a stock. And one of the most popular and effective methods for doing this is an examination of a stocks’s value.
Valuations are a very common metric which investors use in order to evaluate a stock price relative to a company's fundamental characteristics, such as revenue and income. Valuations are an excellent way to "frame" a company's stock price. It enables an investor to distinguish between two companies both carrying a similar stock price by examining underlying key data.
Two of the most common valuation metrics are the price-to-earnings (P/E) and the price-to-book (P/B) multiple. Lower numbers are better and many value investors like to see P/E multiples below 15 and P/B multiples below 3. Our studies show, however, that a company with a valuation below its industry average is more likely to outperform the markets than one that has a P/E or P/B multiple below a specific number.
Synthesizing Two Styles
So now that we have covered the basics of valuations, lets begin our union of these two investing styles in order to add an additional filter to already effective momentum trading strategies.
Let’s assume we have four stocks that have great chart patterns and have provided investors with sizeable returns during the past 12 months. Even though earnings estimates are continuing to be revised upwards, some may question how much upside is left.
Enter valuations. Not only can valuations provide additional information about a stock's capacity to continue an existing trend, they can also help investors identify companies that remain undervalued relative to their peers and therefore are most likely to continue trending upward, as long as earnings estimates are revised upwards.
Below is a list of four stocks and their respective P/E multiples. Based upon current-year earnings projections, Stock D by far has the most attractive P/E multiple, coming in at 13, whereas Stock A looks pricey.
Why Value Makes Momentum Better
The reason this P/E reading is so valuable to a momentum investor is because it quickly shows which companies are still underappreciated and which might have too much excitement already priced into its stock. Just as you probably wouldn’t buy a stock that looks overbought based on technical analysis, you shouldn’t buy a stock that looks overbought based on valuation. Higher valuations imply a greater downside risk.
Assuming projected growth rates are about even, Stock D looks like a bargain. If we simply apply the average multiple of the other three stocks, we can easily justify a 200% increase in the price of Stock D. Now Stock D may not rise according to this exact amount, but based on valuation, it does appear to contain more upside potential than its three peers.
Creating additional layers to an already effective momentum strategy can enable investors to produce even better results. Combining these two particular investment styles, momentum and value, is a great way to reduce risk as well as identify stocks that are ready to accelerate and produce exceptional returns.
Momentum Trader: Blend fundamental with technical analysis to find almost unstoppable stocks. Find out more.
Chart Pattern Trader: Pinpoint high-flying stocks at exactly the right time. Find out more.
Zacks Method for Trading: Learn to spot and trade Momentum Stocks yourself, step by step. Find out more.
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