This is a very interesting question. Every investor keeps asking this question. However, as happens with other existential questions in life, there is no right answer to this question. In other words, it all depends on your judgment.
An investor may expect good earnings from a stock going forward and buy it at a high P/E. Another investor may not share the same enthusiasm and consider it an expensive stock. The right P/E depends on what you consider the earning potential of a stock.
Generally, P/E ratios of 12 to 20 are considered normal across companies with neutral to positive outlooks. Legendary Investment Guru Benjamin Graham said that 20 P/E the maximum one should pay for an investment purchase of a common stock. Many times you see that the P/E ratio of certain companies, sectors or a whole market traverses to dangerous levels. Generally, it happens when emotions run high and people forget the basics of stock valuation. In 2000-2001, we saw how technology companies were trading at 60-90 times their current earnings. These ratios are not sustainable in the long term. Event the best companies cannot deliver the growth required to justify the P/E ratios of 60-90 on consistent basis. Many times investors get into a frenzy of buying stocks that everybody else is buying and pay very dearly for this mistake.
If the P/E ratio of a sector or a company is higher compared to the historical average P/E, you have a reason to investigate the reason for this abnormal behavior. If there is a valid reason for such a high P/E, you may consider buying it otherwise stay away from it. Generally, whenever a sector or a whole market goes beyond its historical average P/E, there is a correction, unless there is a fundamental change in the business scenario. Therefore, when you see a stock with high P/E, you must ask how justified earning expectations are from the stock.
Different industries have different P/E ranges based on their earning potential. You will see many metal companies operating at low P/E ratios. That’s because they have low margins and there’s very little for them to differentiate from their competitors. Hence, their ability to command a price premium from their customers is limited. On the other hand, technology companies generally sell at a higher P/E multiple as people have high expectations from them. These companies in general are able to grow at a faster clip too. Hence, variations in the P/E ranges of different industries are acceptable. One pertinent point here is that high P/E ratio makes a company risky too as its high stock price is based on future expectations rather than its past or current earnings. This is generally true of new technology companies. Many value investors stay away from technology companies as they cant put a price on the value of the technology. Frankly, it’s not an easy task to predict evaluate the business value of a technology with certainty, as tech space keeps changing very quickly. You should, however, not treat all technology companies equally. A few of them like Microsoft, Google, Oracle, etc have developed product portfolios and brand equity that helps them ensure that they have a predictable earning stream. If you can understand how a company is making money and how sustainable its earnings are, you can put a value to its stock. Otherwise, you will be indulging in speculation by buying a stock that you don’t understand.
Cyclical industries generally have varying average P/E ranges based on the phase of the industry. Steel industry goes through a cycle or 8-10 years during which demand in the market goes from low to high to low again. The industry also goes through a complete cycle of high capacity utilization, high capacity creation and low capacity utilization, which leads to further variations in the financials of the companies.
You should also note the limitations of using P/E ratio. Earnings are not cash flow. Many a times, company management try to fool the investors by manipulating earnings in a particular year, as it’s an accounting measure. While you must have a look at the P/E of a stock before making your investment decision, P/E ratio in isolation is not an indicator of the worth of a stock. You must look at the past earnings, changes in the accounting policy and free cash flow of the company to counter this problem.
On its own, P/E ratio is meaningless. It’s an indicator of the value of a stock. It’s not the cause of the value of the stock. It’s an effect. Understand the difference. There must be a fundamental reason why a stock is priced the way it is. Your analysis should help you find this reason. You will also see that some of the companies in a sector trade at a relatively higher P/E than others. There must be a reason for this difference in the companies. May be the companies with a higher P/E are more efficient. Or they have a strong brand that ensures that customers keep flocking to them. If a company is going to launch a potential market-winning product, there is a reason for a high P/E. If a stock has got a low P/E, this is not a reason enough for you to invest in the stock. If there is a regulatory change that’s going to make life difficult for a company, there is a reason for a low P/E. Therefore; you must try to understand the underlying reason for a stock’s P/E variation from the norm. If you are able to get to the root of the variation, you will be in a position to make your own decision on the stock.
Showing posts with label Ratio Analysis. Show all posts
Showing posts with label Ratio Analysis. Show all posts
Monday, October 5, 2009
Monday, September 28, 2009
What is Price to Earning Ratio: Interpreting P/E Ratio of a stock
P/E ratio is a very popular term amongst stock investors. Anybody who is considering investing in stocks does usually find out the P/E ratio of the stocks he is researching. At the same time, strange as it may sound, very few people are able to use the P/E ratio well in their investment decisions. In this post, we will try to understand what P/E Ratio means and how it can help an investor make sound investment decisions.
Calculating PE Ratio:
First things first, let’s understand how we arrive at the P/E ratio of a stock. The formula is
P/E Ratio = Stock Price/ Earning Per Share
Let’s say that a stock has annual Earning per Share of $10, and is trading at $120. In this case, the P/E ratio will be 12. A conservative investor will prefer using earnings from the previous four quarters, while calculating P/E ratio. In fact you can choose to take an average of last 3-5 years of annual earnings, if you really want to act like a true value investor. Averaging helps remove aberrations from the earnings of a stock. However, many analysts consider expected earnings for the next four quarters. A flaw, that too a major one, with this approach is that expected earnings are ‘EXPECTED’ earnings. They can change faster than your mood. And then, everybody has different expectations.
Interpreting PE Ratio:
Simply put, in the example above, assuming that the stock returns the same level of earnings year after year, you should get back your money in 12 years. If you reverse the PE ratio, you will get the Earning Yield of the stock. Earning Yield is a measure of the return from a stock. In this example, you are getting a return of 100/12 or 8.3% per annum on your investment. Remember that all earnings of a company belong to shareholders. Irrespective of what dividend is being paid out to shareholders in the short term, ultimately all the earnings should flow back to the shareholders. Earning yield is a good measure to consider if you are thinking about choosing between other investment options and stocks for investing your money.
P/E ratio gives you an idea of what the market is willing to pay for the company’s earnings. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits too move up, the ratio stays the same. The ratio moves only when price and profits become disconnected.
For this reason, when the P/E ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because market is expecting a change – a change in the performance levels of the company in either direction going forward or a change in the market sentiment. You must make a note of these changes.
A higher P/E means that the market is willing to pay more for a stock compared to another stock with a lower P/E. An interpretation of a high P/E could be that the stock is overpriced. On the other hand, this could also mean that the market has high hopes from the stock in future, and it is factoring in the future earnings of the stock in its current price. Similarly, a low P/E may indicate a stock with low expectations from the market or it could mean an undervalued stock that has been overlooked by the market. Value investors hunt this kind of undervalued stock. Note, however, just because a stock is trading at a low P/E does not mean you should buy it. If it is an undervalued stock, it might be a good bargain. However, if it is a stock, which is not expected to do well in future, you may want to do a little research before you buy it.
You should, however, never consider P/E ratio in isolation. It’s a good measure if you use it for comparison between competitors or with the market or with the same company at different points in time. However, if you choose a telecom company over a steel company based on the difference in their P/E ratio, it may not be a very fruitful exercise.
Different types of P/E Ratios:
Many analysts will use different types of P/E ratios resulting in utter confusion. These can be trailing P/E ratio based on earnings of the last four quarters or forward P/E ratio based on expected earnings of the next four quarters. Using past earnings might not be a great indicator of the future earnings of a stock. However, in reality, past earnings have been better indicators of the future earnings of a stock than the earning forecasts made by stock analyst. It’s not easy to manipulate the value of trailing P/E ratio, as there is no guesswork or wishful thinking involved in calculating it, which is why value investors prefer using trailing P/E while making their investment decisions.
I hope the above post is able to give you a basic understanding of the P/E ratio. The next question in your mind could be what the right P/E for a stock is. I will answer this question in my next post. Stay tuned.
Calculating PE Ratio:
First things first, let’s understand how we arrive at the P/E ratio of a stock. The formula is
P/E Ratio = Stock Price/ Earning Per Share
Let’s say that a stock has annual Earning per Share of $10, and is trading at $120. In this case, the P/E ratio will be 12. A conservative investor will prefer using earnings from the previous four quarters, while calculating P/E ratio. In fact you can choose to take an average of last 3-5 years of annual earnings, if you really want to act like a true value investor. Averaging helps remove aberrations from the earnings of a stock. However, many analysts consider expected earnings for the next four quarters. A flaw, that too a major one, with this approach is that expected earnings are ‘EXPECTED’ earnings. They can change faster than your mood. And then, everybody has different expectations.
Interpreting PE Ratio:
Simply put, in the example above, assuming that the stock returns the same level of earnings year after year, you should get back your money in 12 years. If you reverse the PE ratio, you will get the Earning Yield of the stock. Earning Yield is a measure of the return from a stock. In this example, you are getting a return of 100/12 or 8.3% per annum on your investment. Remember that all earnings of a company belong to shareholders. Irrespective of what dividend is being paid out to shareholders in the short term, ultimately all the earnings should flow back to the shareholders. Earning yield is a good measure to consider if you are thinking about choosing between other investment options and stocks for investing your money.
P/E ratio gives you an idea of what the market is willing to pay for the company’s earnings. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits too move up, the ratio stays the same. The ratio moves only when price and profits become disconnected.
For this reason, when the P/E ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because market is expecting a change – a change in the performance levels of the company in either direction going forward or a change in the market sentiment. You must make a note of these changes.
A higher P/E means that the market is willing to pay more for a stock compared to another stock with a lower P/E. An interpretation of a high P/E could be that the stock is overpriced. On the other hand, this could also mean that the market has high hopes from the stock in future, and it is factoring in the future earnings of the stock in its current price. Similarly, a low P/E may indicate a stock with low expectations from the market or it could mean an undervalued stock that has been overlooked by the market. Value investors hunt this kind of undervalued stock. Note, however, just because a stock is trading at a low P/E does not mean you should buy it. If it is an undervalued stock, it might be a good bargain. However, if it is a stock, which is not expected to do well in future, you may want to do a little research before you buy it.
You should, however, never consider P/E ratio in isolation. It’s a good measure if you use it for comparison between competitors or with the market or with the same company at different points in time. However, if you choose a telecom company over a steel company based on the difference in their P/E ratio, it may not be a very fruitful exercise.
Different types of P/E Ratios:
Many analysts will use different types of P/E ratios resulting in utter confusion. These can be trailing P/E ratio based on earnings of the last four quarters or forward P/E ratio based on expected earnings of the next four quarters. Using past earnings might not be a great indicator of the future earnings of a stock. However, in reality, past earnings have been better indicators of the future earnings of a stock than the earning forecasts made by stock analyst. It’s not easy to manipulate the value of trailing P/E ratio, as there is no guesswork or wishful thinking involved in calculating it, which is why value investors prefer using trailing P/E while making their investment decisions.
I hope the above post is able to give you a basic understanding of the P/E ratio. The next question in your mind could be what the right P/E for a stock is. I will answer this question in my next post. Stay tuned.
Sunday, May 10, 2009
Fundamental Analysis for Investing in Stocks
There are many investment styles- technical, fundamental, growth investing, value investing, speculating, etc. Fundamental Analysis, as the term suggests, is about the fundamentals of a stock. It focuses on understanding the prospects of the business underlying the stock by analyzing the financials of a company, qualitative factors like management quality and economic factors affecting an economy and industry. The aim of Fundamental Analysis is to uncover the intrinsic value of a stock.
Technical analysis is another type of investment analysis that focuses on the momentum of a stock and doesn’t bother too much with the underlying business. Price history of a stock, current momentum, liquidity in the market, investor sentiments, etc are the key factors in technical analysis. A long-term investor should never bother with technical analysis, as short-term trends do not matter in the long run.
Many investors depend on a combination of technical analysis and fundamental analysis for making decisions regarding stock investment. If you are a long-term investor, and are willing to put in some effort in order to make a decent amount of profit from investing in stocks, you will do a world of good to yourself by doing some fundamental analysis before you invest any money.
To be a good fundamental analyst, one needs to master the art of interpreting financial statements. Fundamental analysis starts with analysis of financial statements and various ratios. It takes into account operating cash flows, earning per share, Price to earning ratio, capital structure, earning estimates, current ratio, debt to equity ratio, etc. A fundamental analyst tries to derive the value of a business based on various valuation models. Some of these models are discounted cash flow model and dividend discount model. Apart from analyzing the past financial data of a business, most models depend on assumptions regarding the future growth and risk associated with the business. This factor makes even fundamental analysis very subjective, leading to divergent views about the value of stock in the eyes of different analysts. For knowing more on these stock evaluation models, you can google the terms highlighted above.
Value investing is not very different from fundamental analysis. If you go through the lessons on how to select stocks, you would have covered a major part of fundamental analysis.
It is very difficult to cover the topic of fundamental analysis in one post. Suffice to say that fundamental analysis involves understanding the businesses behind stocks and presents an investor with opportunities to invest in undervalued stocks. For knowing more on fundamental analysis, you can go through other posts on this blog.
Technical analysis is another type of investment analysis that focuses on the momentum of a stock and doesn’t bother too much with the underlying business. Price history of a stock, current momentum, liquidity in the market, investor sentiments, etc are the key factors in technical analysis. A long-term investor should never bother with technical analysis, as short-term trends do not matter in the long run.
Many investors depend on a combination of technical analysis and fundamental analysis for making decisions regarding stock investment. If you are a long-term investor, and are willing to put in some effort in order to make a decent amount of profit from investing in stocks, you will do a world of good to yourself by doing some fundamental analysis before you invest any money.
To be a good fundamental analyst, one needs to master the art of interpreting financial statements. Fundamental analysis starts with analysis of financial statements and various ratios. It takes into account operating cash flows, earning per share, Price to earning ratio, capital structure, earning estimates, current ratio, debt to equity ratio, etc. A fundamental analyst tries to derive the value of a business based on various valuation models. Some of these models are discounted cash flow model and dividend discount model. Apart from analyzing the past financial data of a business, most models depend on assumptions regarding the future growth and risk associated with the business. This factor makes even fundamental analysis very subjective, leading to divergent views about the value of stock in the eyes of different analysts. For knowing more on these stock evaluation models, you can google the terms highlighted above.
Value investing is not very different from fundamental analysis. If you go through the lessons on how to select stocks, you would have covered a major part of fundamental analysis.
It is very difficult to cover the topic of fundamental analysis in one post. Suffice to say that fundamental analysis involves understanding the businesses behind stocks and presents an investor with opportunities to invest in undervalued stocks. For knowing more on fundamental analysis, you can go through other posts on this blog.
Sunday, April 5, 2009
How to find a Growth Stock- what makes a stock a Growth Stock
A growth stock, by definition, is a stock that has a growth rate much superior to average growth rate of the stock market. Ideally, the earning growth demonstrated by a growth stock should be growing at far higher rate than an average stock in the stock market. When people talk about growth stocks, they invariably talk about value stocks in the same breath. The key difference is that much of the valuation of a growth stock depends on its future performance and the valuation of a value stock depends primarily on its past performance.
You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.
Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.
A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.
In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:
· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact
How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.
You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.
Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.
A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.
In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:
· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact
How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.
Saturday, February 14, 2009
How to Select a Stock- Part IV- Financial Stability
In this post we will try to learn how we can ensure that the money we are going to invest in a company doesn’t go down the drain. Essentially, we will try to evaluate the intrinsic financial soundness of the company and understand the financial ratios or filters that we need to apply to remove risky companies from our consideration set.
Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.
Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.
Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.
Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.
Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.
While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.
Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.
Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.
Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.
Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.
Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.
While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.
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