1. Find out the value of the company

The most important thing is to find out the market value or market capitalization of a company. You can calculate it by multiplying the company's current stock price by its number of outstanding shares. For example, you want to invest in Russian VTB or Nornickel shares. After doing simple calculations, you will see that Nornickel's worth is almost twice more than that of VTB.

In the United States, companies choose to split their shares so they can lower the trading price of their stock to a range of $1 to $100, deemed comfortable by most investors.

And finally, owning a share in a publicly-traded company means you have stake in this business. Buying shares, investors do not necessarily rely on the company's market capitalization. They pay attention to other factors, including the brand and quality of a business. For those who consider the latter, the fastest way to assess the quality is to look at the company's revenues.

2. Compare price and quality

To understand the actual stock price you should estimate how soon your investment will pay off. A company will be able to return investors their money only if it shares its profit. That means it needs to pay dividends. But in addition to dividends, the profit can be directed to development of the company's business. In this case, the financial indicators of the issuer may improve, and the shares will rise in price.

To evaluate the value of a stock, compare its price with the company's earnings. Formulas for such valuation are called multipliers. They will allow you to see the correlation between the company's financial results (profit, revenue, debt, capital) and its market capitalization. The P/E ratio is a valuation measure that compares the level of stock prices to the level of corporate profits, providing investors with a sense of a stock's value and showing in how many years the investment will pay off if the stock price and the company's profit remain at the same level.

Let's compare Russia's Gazprom (the price-to-earnings ratio of 3.1) and Netflix (the P/E ratio of 457.6). Assume that Gazprom's P/E ratio declines to 1.55, while the share price and earnings remain at the same level. Even in this case investment in this company will pay off twice as fast. Meanwhile, if you invest in Netflix, you will pay back your investment in 228 years even if its earnings rise twofold.

The earnings multiplier is an adjustment made to a company's P/E ratio that takes into account current interest rates. The earnings multiplier is used to discount future earnings, and allows investors to compare expected growth to an amount of money invested over the same period at current rates. Divide the annual profit into capitalization and multiply the result by 100. Whatever the multiplier you choose, remember that this is only a theoretical forecast that does not take into account external economic factors, news background and public opinion. Multipliers show the value of a company, but do not indicate effectiveness of the business.

3. Invest in a company, not in formulas

There are both conservative industries, which are now at a relatively stable level (oil or gas sectors), and innovative market sectors, where an out-of-nowhere company can turn into a market leader (IT or media business). Gazprom's low P/E ratio means that its share price is unlikely to fall, most likely, it will grow. However, this does not mean that investing in this company is a good idea. Meanwhile, if Netflix doubles its profit twice a year, as it has done so far, the investments in this firm will pay off faster.

Some tips on how to assess the quality of a business

Know what's what. Find out the assets of a firm, what it cashes in on, and its debt load.

Look at the dynamics: the operating profit (which the firm receives from its major main business) and the company's profit growth over the past few years (data is available in Google Finance, Yahoo Finance, Investing.com and Tezis). It is important to pay attention to both aspects. Thus, if Gazprom sells a large stake in its business, revenues will grow, but profits will be lower next year.

One last thing - make your own decisions. The P/E ratio is a good base, it does not predict how much you will earn, but you will understand the potential of your portfolio.