Dr. Paul Prices's series about some basic terms in investing.
The Correct Application of These Key Yardsticks Will Allow You To Avoid Common Investment Mistakes and Maximize Your Long Term Results.
Price / Earnings
Price / Book Value
Price / Cash Flow
Buy 100 shares of stock as if you were buying the whole company. Do not invest in any business which does not give a good current return to the company’s owner(s).
History shows that low P/E, low price/book value, and low price/cash flow shares have dramatically outperformed momentum or growth type issues (Source: Dreman Associates). Resist the urge to own everybody’s favorites of the moment. Even with good news, many of these stocks will be poor performers, and with negative news the share prices can be hurt badly.
Over the long term, dividends have provided about half the total returns from stock ownership. Everything else being equal, a higher yielding stock is better than a lower dividend or non-yielding share.
In bear markets, dividend-paying stocks tend to hold up better than no-yield shares, and they give you “cash flow” to reinvest when shares are cheap.
Historically, there has been an upward bias to the stock market due to the profitability of the majority of its companies. It is futile and counterproductive to try to predict short term fluctuations. Buy stocks when they are offered for well under normal valuations. Of course, past performance is no guarantee of future results.
If the reason for your initial investment is no longer valid, it may be time to sell. If a stock price reaches “fair value” it may be time to sell. If a stock you own goes lower without any news to justify the drop, consider buying more.
It is OK to listen to “Hot Tips” but evaluate them on the same basis as all other stocks. If all the expected returns are from events yet to happen, it is probably better to pass. You do not lose any money by not owning a stock which goes up.
Initial public offerings (IPO’s) are done when the sellers think they can get a great price. Is this a good time to be a buyer? My definition for IPO is: It’s Probably Overpriced.
Merely following “the trend” insures that you can never buy at lows or sell at the top. With a disciplined, unemotional system, you can get the biggest gains with the lowest risks.
Take the emotion out of your decision-making and you will be ahead of 99% of all investors. Logical investing is highly profitable.
To know if a particular stock is overpriced, undervalued, or fairly valued, we must first determine its own normal levels. Just as a doctor must learn “Histology”- the study of normal tissue, before taking “Pathology”- the study of abnormal tissue, we must learn what normal is, before trying to identify abnormal in share prices.
We do this by finding key historical buying and selling opportunities and then determining what this stock looked like [from a valuation standpoint] at those times, based on our four key parameters. When share prices and/or valuations are similar to previous best buying opportunities then risks are likely to be low and potential returns high. Conversely, when all valuation measures resemble previous tops for a given stock, risk will substantially exceed predictable rewards.
Using the Value Line Investment Survey and the Standard and Poor’s stock reports are among the way to get the information we need to determine normal levels. These are available at most public libraries, by subscription, or on request from your friendly broker. One caveat, however, is that many times these publications will recommend buying the stocks which are most overvalued according to our analysis and will steer you away from the best bargains. These publications are great for sources of historical data but will often confuse you with their editorial “buy and sell” advice.
TRUE MEANING OF PRICE/EARNINGS:
XYZ Company has one million shares outstanding. Last year XYZ earned $4 per share after corporate taxes. XYZ shares sell on the New York Stock Exchange for $20 per share. The price is $20, the EPS is $4, thus the P/E is 5.
We are already rich so we will just dip into our bank account and buy all one million shares of XYZ at the $20/share asking price. We now own the entire company for a $20,000,000 investment.
If the company earns the same $4 per share in the next twelve months that it earned last year, we will have made a new $4,000,000 on our $20,000,000 investment. Our $20 million investment has grown to $24 million in one year. Just for simplicity we will assume no EPS growth and just look at the same $4 per share after tax return over the next few years.
(to own the entire company)
|Return at $4 per share year 1||$4,000,000|
|Return at $4 per share year 2||$4,000,000|
|Return at $4 per share year 3||$4,000,000|
|Return at $4 per share year 4||$4,000,000|
|Return at $4 per share year 5||$4,000,000|
|Cumulative Return (5 years)||$20,000,000|
|Value of the Company
(after 5 years of ownership)
The P/E of a company, in its simplest form, tells you how long it would take that company to double its net worth after all corporate taxes. (Assuming future earnings stay the same as in the twelve months prior to purchase).
‘EARNINGS YIELD’ DEFINED:
The inverse of the P/E is called the “Earnings Yield” and represents the last twelve months after-tax return to the owner of a company based on the actual reported earnings and the current share price.
Thus a P/E of 5 would have an Earnings Yield of 1/5 = 20%
A P/E of 10 would have an Earnings Yield of 1/10 = 10%
A P/E of 20 would have an Earnings Yield of 1/20 = 5 %
A P/E of 50 would have an Earnings Yield of 1/50 = 2%
As the current P/E gets higher, the Earnings Yield gets worse. This means that investors who buy high P/E stocks are accepting low current returns in the hope of enough earnings growth later to justify their current premium prices. Low P/E stocks are already giving fine company returns and do not need growth to justify their present share prices.
Studies have shown that corporate earnings estimates are often wrong by considerable margins. Paying in advance- for good news which has not yet happened- can often be very expensive. Buying “low expectation” stocks, however, often generates positive surprises. Plus, anticipated bad news may not do much [or any] damage to your returns.
In the short run the “company return” and the “shareholder return” do not always correlate. Over the long run, however, the true value of a company is almost always reflected in its share price. This is the essence of “Value Investing”. Find good solid companies, which are selling for less than their current true values. Hold these shares until the investment community becomes more enthusiastic towards this industry or company. When the shares become fairly valued or overvalued, sell, and move into stocks which are then “out of favor’. Instead of needing to own particular companies or industries, you will do better by buying what “the market” is willing to give you for less than its proper valuation.