Considering equity investors are involved in a risky endeavor, it is essential they build a defense against investing mistakes. As an equity investor, there are no creditor protections. Management can issue new shares that dilute your share of the company. Numbers are frequently "massaged" to make earnings look good in order for management to get a nice bonus. This is just a short list of the dangers in equity investing. We must build strategies that defend against the risks.
One of the first and most simple methods an investor should consider is studying sales. Once we ingrain the fact that, as an investor, we are buying a company that sells products and services, we can then put a price on revenue. Knowing how much is retained after paying suppliers, employees, creditors, and tax agencies we will have the ability to determine if the price being paid is fair. Let us take LM Ericsson Telephone Company (ERIC, Financial), a 1-Star Business Predictability ranked, "provider of communications networks, telecom services and support solutions."
The first question is to determine if the product or service is necessary for society. Investors in buggy whip companies learned quickly how the steering wheel replaced the need for buggy whips. The need for quick and easy communication will always be important to an advanced society. The product that transfers messages, however, will be different.
Therefore, we must monitor revenue and determine if the new products and services will continue being important to society. Below is a chart of the revenue from the products and services Ericsson has developed. From $10 billion in sales to $34 billion, Ericsson product have grown in importance to society. This does not mean they will continue to be. 
The next aspect we must consider is the price we are paying for that revenue. Notice the market cap of ERIC in 2000 at $200 Billion. Growth investors at that time were buying the revenue (green line) for a substantial premium. This was the time of the internet bubble when most technology companies were overvalued. The important thing is to know what you are buying is revenue, the green line, and the price being paid is the blue. Value investors want the green, but only at a discount, as was offered in 2003.
Some people prefer to view this data in another format. They divide price by sales and get a Price to Sales ratio. It is easier to think of the P/S ratio as the price being paid for $1.00 in revenue. Take a look at how much speculative growth investors were paying for $1.00 in revenue. In 2000 they were paying nearly $8.00 for $1.00 in revenue. A couple years later value investors got that revenue for $0.20.
We must know what we are buying. Understanding price is sometimes overvalued and occasionally undervalued is essential to investment success. There are too many risks in investing in equities for us not to do our investment homework. Study the charts and value the revenue. Maintain rationality in times of greed and despair.
Thanks to Gurufocus.com for providing Ericsson Interactive Charts.
