Determining whether the risk/reward ratio is favourable or not for a particular company is hugely subjective.
After all, some investors would argue that it is better to seek out companies that have relatively cheap share prices, and which therefore offer a considerable margin of safety, even if their prospects are somewhat uncertain. Others, meanwhile, feel that buying a company with a great track record and bright future prospects for a reasonable price is much more favourable.
Either way, it's perhaps best to consider the merits of stocks on a case-by-case basis, since there doesn't appear to be a 'catch-all' method that works all of the time. So, with that in mind, here are three stocks that I believe have favourable risk/reward ratios at the present time, but for slightly different reasons.
Ramsay Health Care Limited
A quick glance at the valuation of Ramsay Health Care Limited (ASX: RHC) indicates that it is by no means a cheap stock. For example, it currently trades on a P/E ratio of 30.5 and has seen its share price rise by a whopping 10% in the last three months alone.
However, the private hospital operator could continue such rapid growth moving forward since it offers a combination of stability and growth that few stocks in the ASX can match. For instance, it has a hugely stable business model that is relatively unaffected by changes in the outlook for the local and global economies, while its push into Europe and China means that it has considerable growth potential, too.
It also has a PEG ratio of 1.68, which seems to offer good value for money at its current price level. It can perhaps be summed up as a great company trading at a reasonable price. As such, it could make big gains over the next year.
CSL Limited
Also deserving of a premium compared to the ASX is CSL Limited (ASX: CSL). It is also in high demand at the moment due to its business being relatively uncorrelated with the economic cycle, which is a key reason why its P/E ratio has expanded to 26.9 during the course of 2014.
However, it could go even higher, since it continues to offer a relatively rare combination of growth potential and defensive prospects. For example, its bottom line is forecast to rise by 24% in the current year, followed by 9.9% in the following year.
This means that in just two years' time, CSL's bottom line is all set to be 36.3% higher than it was last year, and with it being a relatively defensive play the chances of it meeting its forecasts are relatively high. As such, its current P/E ratio (and PEG ratio of 1.61) appears to be a reasonable price to pay.
Woodside Petroleum Limited
As with CSL and Ramsay, Woodside Petroleum Limited (ASX: WPL) is a high-quality business. A key difference though is that its profitability is far more dependent upon external factors, such as the price of oil. However, with oil now trading below $60 per barrel, Woodside's profitability over the short to medium term is set to disappoint.
However, this could present a major opportunity for investors, with Woodside's risk/reward ratio now seemingly very favourable. Certainly, earnings are forecast to fall next year, but Woodside's P/E ratio of 10.5 seems to price this in.
It also seems that Woodside is viewing the current demise of the oil price as an opportunity to buy high-quality assets at discounted prices (through acquiring LNG and oil interests in Canada from Apache Corporation for US$2.8 billion). Therefore it could make sense for investors to view the company in the same light.
As such, now could be a great time to buy Woodside, with it having considerable upside potential over the long run.
