What's a good stock to buy? For an investment premise purchase, there are always two parts to this question: 1) the company's business prospects 2) the price. Unfortunately, many investors neglect the second part of the question.

Stocks can be purchased for a variety of reasons. But an investment premise, which is a desire to own part of a company that will grow into a bigger, more profitable company, is the most common. (Others include: trading, momentum, technical analysis, quantitative analysis, arbitrage, etc.)

After all, this is what most people mean when they say "a good stock." They really mean a good growth company.

The problem is that to be a good stock, a company with good growth prospects must also have a good stock price.

Stocks are not like other consumer items. The price continually changes.

Additionally, since the primary purpose of buying stocks is to see their value increase, the price is the most important factor.

This is extremely important to remember when first establishing a position. Remarkable as it sounds, it's often forgotten.

It's particularly easy to forget when someone, such as a friend, recommends a stock. Often the friend's recommendation of a good stock is one that has already returned a lot of money. Your entry into the same stock at a much higher price could be very different.

So how can you tell if a stock is trading at a good price? The best way is through valuation.

The actual price of a stock is irrelevant. The market capitalization is the only important figure.

Market capitalization can be defined as follows:

Total shares outstanding times the share price equals Market Capitalization

The market capitalization represents the price of the entire company. Each share of stock represents only the proportional value of that total price.

Market capitalization is important because it allows for comparison to other companies, using price related ratios.

The two most important price related ratios are Price/Earnings and Price/Sales.

Price/Earnings ratios, or P/E, was the dominant driving valuation standard during the 1980s and early 1990s. This ratio takes the price per share divided by the earnings per share of the company.

Price/Sales, or P/S, became a more dominant valuation standard for technology stocks in the latter part of the 1990s. This ratio takes the price per share divided by the revenue per share. Or, more simply, P/S is the market capitalization of the company divided by the revenue of the company.

The primary purpose of both of these two ratios is for comparison to other companies in the same industry. Whether a stock is "expensive" or "cheap" is largely determined by the relationship of the P/E or P/S to other similar companies.

When you hear people talking about multiples, they are primarily talking about the price/sales or price/earnings ratios of the stock.

A high multiple implies that either or both of the P/S or P/E ratios are higher than that of other comparable stocks.

Note that sometimes, prices fall simply because the market is no longer willing to pay a high multiple for a stock, no matter what is happening to the company's underlying business.

In general, per share stock prices are meaningless.

Only the overall market capitalization for the company is important.

There is no difference between a stock with 100 million shares outstanding selling at $20 and one with 10 million shares outstanding selling for $200. Both companies are worth exactly the same amount: $2 billion.

However, this statement is generally not true for stocks less than $5.

Stocks selling for less than $5 fall into a completely different category, and this becomes true the lower the stock price falls.

A company with 10 million shares selling at $1 is very different than a company with one million shares selling for $10.

There is generally greater price support at levels higher than $5. This means the market capitalization is a more accurate valuation of the entire company. When stock prices fall below $5, the value of the market capitalization becomes less meaningful, and no longer truly reflects the price someone would pay for the entire company.

So what is a good price to pay?

This is the hardest question of all. The first step is to make a comparison to other stocks in the same industry. But this can be misleading, because the best stocks, like the best anything, always cost more.

A high valuation implies a high expectation of growth. It takes a while to learn how the market reasonably values growth, and how to gauge whether a high valuation is too high.

Making this judgment harder is the fact that the market's opinion of what is high is always changing. In the end, only experience can help you determine a "good price." But there are good growth stocks, at good prices, in the market at all times. It is just a matter of looking for them.

It's all pretty simple: a good stock is one which:

• Has good business potential
• Has a stock price that doesn't yet fully reflect that potential

Robert V. Green