Tag: P/E ratio

  • What is GARP And GARP Investing?

    What is GARP And GARP Investing?

    What is GARP And GARP Investing?
    The definition of GARP stock can vary but is based on the P/E to PEG ratio, which divides the P/E ratio by the growth rate.

    What is  GARP or longer, Growth At a Reasonable Price? Growth at a reasonable price or short GARP is an investment strategy. This strategy unites the principles of both growth and value investing. How does it do that?  When you find the companies that have consistent earnings growth but don’t sell at too high valuations. This term was introduced by investor Peter Lynch.  

    While combining principles of growth investing and value investing it serves traders to pick individual stocks. GARP investors look for companies with steady earnings growth that is higher than market levels. That means they are eliminating companies that have very high valuations. The general goal is to avoid the extremes in any type, growth, and value investing.

    GARP investors invest in growth stocks but such that have multiples low price/earnings (P/E) in average market conditions.

    What is GARP Investing?

    GARP investing or growth at a reasonable price is a combination of value and growth investing, as we said. GARP investors seek companies that are slightly undervalued but with sustainable growth potential. Their criteria are almost the mixture of those that the value and growth investors use. Stable earnings growth is still on top position as one of the most important features but also valuation has a great influence on whether they pick a particular stock or not.

    Building such a portfolio that consists of “Growth At a Reasonable Price stock” isn’t just picking the stocks with an equivalent amount of growth and value. The point is to choose the stock that each has qualities of both, value and growth.

    Aggressive growth investors never pay too much attention to the value of the stock. Here are some reasons why they should consider the value of the stock. Let’s say that growth investors profiting from stocks with excellent earnings growth. Such companies are beating all earnings estimates all the time. Do they have any guarantee that the companies will resume performing with success and how long? They could make a profit only if the company proceeds to generate high profit and grow constantly. But what will happen if it stops to do so? 

    Here we have the value in the scene. Value is important to understand the level of investors’ expectations related to the particular stock. Also, value is helpful to gauge how far some growth stock could drop if it starts to sink. To put this simple, value adds a portion of reasonable thoughts and exact estimates into the calculation. 

    How does GARP work?

    A basic formula for finding GARP is the PEG ratio. It is aimed to measure the balance between growth and value. The optimal PEG ratio should be one or under the one.

    Here is how it works. Let’s say the company is trading at $50 per share with EPS forecasted to rise for15% over the year. 

    P/E ratio = $50/$5 = $10
    PEG ratio = 10/15 = 0,66

    This PEG which is less than 1, makes this company a good candidate for GARP.

    Why does Growth At a Reasonable Price matter?

    This could be an added explanation of what is GARP. GARP helps investors to avoid the possible problems or traps that they may have with complete investing in growth or value stocks. If growth stocks rise too high they may create a bubble that could burst in a minute. On the other hand, value stocks can stay the same in the price for a long time. With GARP investors could find the golden middle zone. The investment stability where they can benefit from rising prices of growth stocks but, at the same time, they’ll be protected with value stocks if the growth starts to fall.

    Some may say that GARP stocks will underperform growth stocks in a growth market. Also, such will notice that GARP stocks will underperform value stocks too but in the value market. Despite these criticisms and objections, GARP could easily outperform in combined markets and could do it over a long time.

    What is a GARP strategy?

    It is a mixed approach to growth and value stock-picking. This kind of investor obtains a combination of returns. In other words, the GARP investing strategy is hybrid.
    In GARP investing it is necessary to look for low price/book ratios and a PEG ratio of less than one, as we said.

    P/B ratio = current price/book value per share
    PEG ratio = P/E ratio/predicted growth in earnings

    We said a GARP investor will obtain a combination of returns. This actually means, when markets are dropping it is better for value investors. Hence, markets are rising. It is better for growth investors. On the other hand, GARP investors could benefit from any market condition because they are somewhere between the mentioned types of investors but unite characteristics of both.

    What is it in essence?

    Growth At a Reasonable Price investing doesn’t have inflexible limits for adding or eliminating stocks. The basic benchmark is the PEG ratio. The PEG presents the ratio between a company’s valuation (P/E ratio) and its required earnings growth rate for the next several years, for example. If stocks have a PEG of 1 or less,  that means the P/E ratio is in line with predicted earnings growth. This helps to find a stock that is trading at a reasonable price.

    During a bear market or other declines in stocks, the returns of GARP investors could be higher than the growth investors can get. However, in comparison to the value investors, GARP investors may have average or under average returns. But since GARP investors hold stocks with characteristics of both growth and value stocks, the average returns they get is higher than average returns for growth and value investors can get from their investments separated.

    Bottom line

    GARP stocks are picked by a joining of earnings growth and valuation when investors want to evaluate the right picks. The idea behind this is to recognize cheap stocks with a growing possibility in the future. Hence, the earnings growth of GARP stocks is notable above that of the market.

    GARP is the abbreviation for “growth at a reasonable price” and represents truly a combination of value and growth investing. So, GARP investors seek for a stock that is trading for somewhat less than its predicted value but has earnings growth potential. GARP stocks are slightly lowered but can grow soon. So, what is GARP? It’s all about how to find stocks that have a future.

  • How to Value a Company And Find The Best To Invest?

    How to Value a Company And Find The Best To Invest?

    How to Value a Company?
    For investors, company valuation is a crucial part of determining the potential return on investment. Start by looking at the value of the company’s assets. 

    One of the most confusing questions for all beginners in the market is how to value a company. The worth of the companies is important for every investor. And the question of how to value a company has a sense for any investor, entrepreneur, employee,  and for any size company. Thus, you have to find the best way to determine the worth of the company. Do you need to ask to see the company’s books or you can value a company based on the existing customers or news? How much time will it take to learn how to value a company? When you notice some interesting companies where to go first? Yes, you can ask in many ways how to value a company.

    The first comes first.

    For every investor, the value of a company is a crucial part of determining the potential returns on investment. Every investor should know if the company is fair valued, undervalued, or overvalued because it has a great impact on a company’s stock or stock options. 

    For example,  a higher valuation might indicate the options will grow in value.

    So, if you want to know how to value a company, be prepared to take into consideration a lot of the company’s attributes. This includes revenue and profitability growth, stage of growth, operating experience, technology, commodity, business plans. Yes, but the list isn’t full without market sentiment, growth rate, overall economic circumstances, etc.
    To understand how to value a company in a simple way, you can take a few factors into account. 

    What metrics to use to value the companies?

    Here is how to value a company and basic metrics you can use for that. You can use the P/B ratio and P/E ratio. These two metrics are important when you want to evaluate the company’s stock. These basic metrics you can apply to almost all types of companies. But it is important to know the other and often unique factors that can affect the process of how to value a company.

    One of the variables in the valuation of a company’s health is debt. But a company’s debt is not continually easy to measure or define. So this metric can make the company’s value difficult to value.

    When you want to value a company or stock, it is smart to use the market approach that includes a comparative analysis of precedent transactions and the discounted cash flow which is a form of intrinsic valuation since it is a detailed approach, and also uses an income approach.

    How to value a company’s stock?

    There are several methods that may give you insight into the value of companies’ stocks. 

    They are the market approach, the cost approach, and the income approach. The cost approach means that a buyer will buy a share of stock for no more than a stock of equal value. The market approach is based on the belief that in free markets, supply and demand will push the price of a stock to a point where the number of buyers and sellers match. The income approach defines value as the net current value of a company’s future free cash flows.

    Market value as a method on how to value a company

    The market value is simple. It represents the shares trade for but tells us nothing about stock’s intrinsic value. Thus, we have to know the stock’s true worth. This is a key part of value investing.
    The stock value is shown in stock price. The P/E ratio is helpful to understand this value. To calculate the P/E ratio just divide the price of a stock by its earnings per share

    When the P/E ratio is high it is a signal for higher earnings for investors. This ratio is helpful to use if you want to know how to value a company. The P/E ratio shows the company’s possible future growth rate. But you should be careful when using the P/E ratio to compare similar companies in the same sector.
    Investors connect value to stocks with P/E ratios. If the average P/E ratio is, for example, 20 – 23 times any P/E ratio above 23 times earnings is classified as a company that investors keep in high 

    Investors and traders use the P/B ratio to compare the book value of a stock to stock’s market value. To calculate the P/B ratio use the most recent book value per share and divide the current closing price of a stock by it. If the P/B ratio is low you can be sure the company is undervalued. This metric is very useful if you want to have accurate data on the intrinsic value of the company.

    But be aware, there are several P/E ratios and numerous variations, thus you have to know which one is in play. For more about this READ HERE

    Cost approach or book value

    Book value is the amount of all of a company’s tangible assets (for example equipment) after you deduct depreciation. So, when we are talking about the company’s “net capital value” it means the book value, estimated by the company’s book of net tangible assets over its book of liabilities. To calculate the book value you have to divide the net capital value by the number of outstanding shares. The result is a per-share value. The book value never takes into account the brand, keep that in mind.

    Income as a method on how to value a company

    Use the capitalized cash flow to calculate a company’s worth when future income is expected to stay the same as it was in the past. But if you expect the income is going to vary, use the discounted cash flow method.

    Calculations are simple, divide the result from capitalized cash flow or discounted cash flow by the number of shares outstanding and the figure you get is the price per share.

    Bottom line

    By understanding how to value a company you’ll be able to understand the essence of making investment decisions. No matter if you want to sell, or buy, or hold the shares of stock in some company. Warren Buffett, for example, uses a discounted cash-flow analysis.
    Sometimes, the company valuation is held as the market capitalization. So, to know the value of the company you have to multiply all shares outstanding by the price per share. For instance, a company’s price per share is $10 and the number of outstanding shares is 4 million. If we multiply the price per share by the number of shares outstanding we will find this company is 40 million worth.

    To be honest, it isn’t too hard to value the public company. But when it comes to private companies it can be a bit harder. You can be faced with a lack of information. For example startups. They don’t have a financial track record and you have to value these companies based on the expectation of future growth. To value an early-stage company can be a great challenge. 

    Before you invest in any company, you’ll need to determine its value. This is important because you need to know if it is worth your time and money. Think about the company’s value as its selling price. Maybe it is the simplest way.

  • Shiller CAPE Ratio – The Measurement Of Market Valuation

    Shiller CAPE Ratio – The Measurement Of Market Valuation

    Shiller CAPE Ratio – The Measurement Of Market Valuation
    The Shiller P/E or the cyclically-adjusted price-to-earnings (CAPE) ratio of a stock market is a market valuation metric that eliminates change of the ratio caused by the difference of profit margins during business cycles. It is the regular metric for evaluating whether a market is overvalued, undervalued, or fairly valued.

    Shiller CAPE ratio or the cyclically-adjusted price-to-earnings ratio of a stock market is one of the regular metrics if you want to evaluate whether a market is overvalued, undervalued, or fairly valued.

    Shiller CAPE ratio, developed by Robert Shiller, professor of Yale University and Nobel Prize Laureate in economics. This ratio usage increased during the Dotcom Bubble when he claimed the equities were extremely overvalued. And he was right, we know that now. Shiller P/E is actually a modification of the standard P/E ratio of a stock.

    Investors use this Shiller CAPE ratio mostly for the S&P 500 index but it is suitable for any. What is so interesting about the Shiller CAPE ratio? First of all, it is one of several full metrics for the market valuation able to show investors how much of their portfolios should wisely be invested into equities. 

    The ratio is based on the current relationship among the price of equities you pay and the profit you get in return as your earnings.

    For example, if the CAPE ratio is high it could indicate lower returns across the following couple of decades. And opposite, a lower CAPE ratio might be a sign of higher returns across the next couple of decades, as the ratio reverts back to the average.

    Investors use it as a valuation metric to forecast future returns. The metric has become a popular method to get long-term stock market valuations. To be more precise, the Shiller CAPE ratio is the ratio of the S&P 500’s (or some other index) current price divided by the 10-year moving average of earnings adjusted for inflation.
    The formula is:

    CAPE ratio = share price / average earnings over 10 years, adjusted for inflation

    That was the formula but let us explain a bit more how to calculate the Shiller CAPE or also called Shiller’s P/E ratio.
    What you have to do is to use the annual earnings of the company in the last 10 years. Further, adjust the past earnings for inflation.  

    How the Shiller CAPE ratio works

    As an investor, you know that the price is the amount you have to pay, and the value is the amount you get. That’s clear. We have to compare the price to the value and that’s why we have many metrics to do so. One of them is the P/E ratio, read more HERE.

    It is legal that everyone wants to buy a healthy company when the shares are trading at a low P/E ratio. This means you can get lots of earnings for the price you paid. This is valuable for index too. Just take an aggregate price of the shares of the company from, for example, the S&P 500 index for one year and divide that number by the aggregate company’s earnings for that year. You will get an average P/E for the index.

    But it isn’t quite true. For example, during the recession. At the time of the recession stock prices will fall as well as companies’ earnings (okay, they may fall significantly sharper). The problem is that the P/E ratio can rise temporarily. The investors want to buy when this ratio is low but temporary high P/E can send them a fake signal that the market is overpriced. And what is the consequence? Investors wouldn’t buy at the time when it is the best solution.

    So, here is the Shiller CAPE ratio to fix that. Shiller invented a special version of the cyclically-adjusted price-to-earnings ratio to help fix this simple calculation. If we use his CAPE ratio we’ll have a more accurate understanding of the ratio between current price and earnings. This ratio employs the average earnings over the past business cycle, not just one year that may have bad or good earnings.

    The importance of the ratio

    Shiller himself explained this the best. He used 130 years of data and noticed that the returns of the S&P 500 over the next 20 years are fully inversely connected with the CAPE ratio at any observed period. How should we understand this? Well, when the CAPE ratio of the market is high, that means the stocks are overvalued. So, the returns in the next 20 years will be lower. Hence, if the CAPE ratio is low, we can be sure the next 20 years the returns will be satisfying. 

    This is natural and logical. Cheap stocks can increase in price no matter if it is from a growing company’s earnings or a rising P/E ratio. Contrarily, when stocks are expensive and have a high P/E ratio, they don’t have too much space to grow. It is more likely they have more chances to drop when market correction or recession comes.

    How to use the Shiller CAPE ratio

    Shiller warned against using CAPE in short-term trades. The CAPE is more helpful in predicting long-term returns. Siller said in an interview:  “It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent — wait until it goes all the way down to a P/E of 7, or something.”

    But really, you have to combine CAPE with a market diversification algo or some other tool for that. Maybe the most important part is that you never get fully in or fully out of stocks.  As the CAPE is getting lower and lower, you are moving more and more in. We think the CAPE ratio for March this year is 21.12. Check the Shiller P/E ratio HERE

    So, it isn’t super high. We, at Traders-Paradise, think the stocks should be an important part of your portfolio. Don’t get out of the stocks and go in cash because the CAPE is at 21. It is smarter to buy less and expect poorer returns in the next several years. Some experts noted that markets are most vulnerable when the Shiller P/E is above 26 like it was in February this year. Some stats show that investors respecting Shiller’s ratio are doing better.

    Bottom line

    Since Shiller showed that lower ratios signify higher returns for investors over time, his CAPE ratio becomes an important metric for predicting future earnings.

    There are criticisms about the use of the CAPE ratio in predicting earnings. The main matter is that the ratio doesn’t take into account changes in the calculation of earnings. These kinds of changes may turn the ratio and give a negative view of future earnings.

    The CAPE ratio was proved as important for identifying potential bubbles and market crashes. The average of the ratio for the S&P 500 Index was between 15 -16. The highest levels of the ratio have exceeded 31( February 2020). For now, the Shiller CAPE ratio announced market crashes three times during history: Great Depression in 1929, Dotcom crash in 1990, and Financial Crisis 2007 – 2008.

    Opponents of the CAPE ratio claim that it is not quite helpful since it is essentially backward-looking, more than it is forward-looking. Another problem is that the ratio relies on GAAP earnings, which have been changed in recent years. 

    The proponents claim the Shiller P/E ratio is good guidance for investors in determining their investment strategies at various market valuations. 

    Historical data show that when the market is fair or overvalued, it is good to be defensive. When the market is cheap, companies with strong balance sheets can produce great returns in the long run.

  • Ratios Important To Make Profit In Stocks

    Ratios Important To Make Profit In Stocks

    Ratios Important To Make Profit In Stocks
    If you want to buy stocks, the wrong way is to follow your intuition and expect everything will work spontaneously. 

    By Guy Avtalyon

    Ratios important to make a profit in stocks is something we will explain to you why that is and how to calculate and examine them. The truth is, you have to favor investing and trading strategies to eliminate emotions. These ratios will give you insight into a company’s fundamentals and let you evaluate a company’s health.
    Stock investing demands a rigorous analysis of financial data if you want to find out the company’s real worth. Investors commonly estimate profit, losses, check business accounts, cash flow, balance sheets. You might think it is too much work and give up or, what is really dangerous, you might buy a stock without any estimation, like you are buying a lottery ticket. Yes, sometimes evaluating the right stock can be hard and eat your time. The question is why should you do that? Instead, you can find a lot of these data free on the internet.

    Understand ratios before buying

    Much more before you buy stocks, it is very valuable to know how to calculate, understand, and read ratios when you see them. It doesn’t matter if you get them from your broker or you find them on the internet. Ratios are important to make a profit in stocks because they will tell you everything about the company you want to invest in. If you don’t estimate the ratios, the possibility of making the wrong investment decision will increase. Just ask yourself, do you really want to invest in a company with debt, that hasn’t enough cash to maintain it or support the operations, and moreover, has low profitability? To be honest, estimating ratios or calculating them isn’t a foolproof method but it is a way for fast checking of the company’s health.

    What ratios are important to make a profit in stocks?

    The most common categories are related to earnings and the balance sheet since they are crucial indicators of a company’s health. The crucial ratios show the company’s income and its ability to persist solvent. But you can use a lot more ratios important to make a profit in stocks and we would like to show you how to put them to work to help you make a proper investment decision.

    So, let’s start!

    P/E Ratios Important To Make Profit In Stocks

    It is the most usually mentioned ratio. The price-to-earnings ratio is sometimes called P/E or just pE ratio. This ratio measures the share price correlated with the earnings per share. The P/E ratio is helpful when you want to compare the stock of one company with the stock of some other from the same industry. By using it you’ll be able to unveil if some stock is underpriced, overpriced, or in harmony with other companies in the same industry. This ratio is a very popular metric and the calculation is quite simple. All you have to do is to divide the value per share by earnings per share for one company. Calculate this ratio for the last four quarters (of course you can do this for several years) and if all of them were equal remember, the lower the P/E ratio is better.

    Use forward earnings

    Also, use forward earnings, which is the average of Wall Street’s projections for the current fiscal year. According to Benjamin Graham, it is proposed the stocks should trade for a P/E multiple equal to 8.5 times earnings plus doubling the growth rate of earnings. If you want to estimate some cheap stock, well, the P/E ratio maybe isn’t an adequate metric.

    For example, the S&P 500 trades for 19,47 times during the past four quarters of earnings reports. The average P/E for the last 80 years is 15.86, which means the market is a little pricey. This is just an example and figures can be inaccurate at this moment.
    So, if the P/E ratio is lower than average, it’s a sign that you’ve found a potential bargain. Well, you don’t have all the relevant data to decide whether to buy a stock or not. A lot depends on growth, so the next ratio to watch is the PEG ratio.

    PEG ratio

    The PEG ratio is a pick of growth investors. To calculate it just divide the P/E by the company’s growth rate earnings expected in the next five years (this is the most accurate). Again, Graham, of course, and efforts to gauge the size of a discount or premium you will pay for growth. If the PEG ratio is less than 1 (which is low PEG), it implies the stock can be undervalued. Contrary, if the PEG ratio is higher than 1 or more, it is an indicator that the stock is overvalued. But the PEG ratio isn’t ideal, it has some downsides. By using the PEG ratio you are not able to predict future growth rates.

    Use Price-to-Sales Ratios important to make a profit in stocks

    P/S ratio is similar to the P/E ratio and to calculate it just divide the market capitalization by the company’s total sales for the last 12 months. So, put aside the earnings. This ratio will tell you how much you will pay for every single dollar in yearly sales. To make clear why we have to put aside the earnings. Well, there are periods when the company doesn’t have earnings so the total sales can tell better about the company’s value than the P/E ratio can. Maybe even more, because no one can manipulate the sales, earnings are something that can be manipulated. If the P/S ratio is low in comparison to other companies, that means a company could be a winning investment.

    But be careful, sometimes a low P/S ratio can be spoiled if the company has a huge debt and permanent lack of profitability.

    Price-To-Book or P/B

    Use this ratio to compare the stock price to the company’s book value. A P/B is expressed as a difference between assets and liabilities, meaning assets minus liabilities. If P/B is low it may indicate a good buying opportunity. When the book value per share is higher than the stock price, it is an indicator that the stock is undervalued. The idea behind is to understand how much money you’ll have in case you sell all of it.

    This is price multiple metrics. The P/B is used when comparing current multiples to historical averages. This ratio is useful for comparing the companies that provide some kind of services, for example, meaning they don’t have a real property. For instance, the equipment company has little book value but trade at very high P/B value multiples, sometimes 25 times over book value.

    Price/Cash Flow or shorter P/CF ratio

    It measures the value of a stock’s price related to its operating cash flow per share. It is particularly helpful for evaluating stocks that have positive cash flow but have non-cash charges and are not profitable.

    The formula is

    P/CF = share price / operating cash flow per share

    You have to count the operating cash flow for the previous 12 months. Further, have a focus on cash generated by the company, forget depreciation from earnings, or amortization. This measure is better than the P/E ratio to compare the valuations of companies from different countries. You know that different countries have different depreciation charges and that may influence earnings. Lower P/CF is better, but remember, almost all companies have extra cash flow, not all is coming from the operations. 

    For example, free cash flow. It is the amount that the company owns after paying debts, dividends, buying back stock. If cash flow is negative it shouldn’t be a red alarm until it becomes a constant problem. If that is the case, the company can easily meet the solvency problem.

    Why ratios are important to make profit in stocks?

    Ratios important to make a profit in stocks are also dividend yield, dividend payout ratio, return on assets (ROA), return on equity (ROE), profit margin, a current ratio, etc.

    There are so many tools, websites, reports that are useful. You have to analyze a stock before you buy it. Also, you have to know the time frame of your investment. We always say stock trading is different, it isn’t the same as investing. Researching stock will take some time, you can’t finish it in a few minutes. But it is completely irresponsible to buy any stock without researching and evaluating by using ratios mentioned above. 

    If you are a trader maybe this can help you. Test it with our preferred trading platform virtual trading system. In investing, permanent study and examination are crucial.

  • P/E Ratio An Quick Method to Value a Stock

    P/E Ratio An Quick Method to Value a Stock

    P/E Ratio An Quick Method to Value a Stock
    Investors use the P/E ratio to unveil the relative value of a company’s stock. Also, the P/E ratio can be used to compare a company’s historical data or to compare markets as a whole over time.

    By Guy Avtalyon

    The  P/E ratio or price to earnings ratio calculates the market value of a stock in relation to its earnings and do it by comparing the market price per share by the earnings per share. To put this simple, the P/E ratio indicates how much the market wants to pay for a particular stock based on its current earnings.

    Investors often use the P/E ratio to assess a stock’s fair market value by predicting future earnings per share.

    It is one of the most broadly used methods for determining a stock value. It can show if a company’s stock price is overvalued or undervalued. But the P/E ratio can reveal a stock’s value in comparison with other stocks from the same industry. This ratio is also called a “multiple” because it shows how much an investor is willing to pay for one dollar of earnings

    That is why the P/E ratio is also called a price multiple or earnings multiple. Investors use this ratio to determine how many times earnings they are willing to pay.

    Calculate the P/E ratio

    The formula is simple. Just divide the market value price per share by the company’s earnings per share.

    P/E ratio = share price/earnings per share

    Earnings per share or EPS is the volume of a company’s profit for each outstanding share of a company’s common stock. It is a kind of indicator of financial health. Earnings per share present the part of a company’s net income that would be gained per share if all the profits is paid out to its shareholders. If traders and investors want to discover the financial health of a company they use EPS.
    In P/E calculation, the amount of “earnings” or “E” is provided by EPS.

    P/E = EPS/Saher Price

    Where the symbols show:

    P/E = Price-to-earnings ratio
    Share Price = Market value per share
    EPS = Earnings per share

    ​ For example, at the end of the year, ABC company reported basic or diluted earnings per share of $3 and the stock is selling for $30 per share. Let’s find the P/E ratio:

    EPS = $4
    Share Price = $30 

    This ABC company P/E ratio was: 

    P/E = $30/$4 = $7.50

    So, the company was trading at ten times earnings. So what? This indicator isn’t helpful without comparison to something. As we said, this figure has to be compared to the historical P/E scale of this company stock, or to peers from the same industry.

    For example, this P/E ratio was lower than the S&P 500 (the S&P 500 average is about 15 times earnings) but we can compare this P/E ratio to peers. And we noticed that the company XYZ had the P/E ratio of 11 at the end of the same year. What can we conclude? Well, ABC’s stock is undervalued. It is lower than, for example, the S&P 500 and for the same period, had lower P/E than its peers.

    You can calculate this ratio for each quarter also but it is common to calculate it at the end of the year.

    Use the P/E ratio to calculate earnings yield

    This is particularly useful. The formula is actually inverted P/E ratio and looks like this:

    Stock’s Earnings Yield = (EPS / Share Price) x 100

    or in our ABC company case:

    earnings yield = (4/30) x 100 = 13.33

    Can you see, to calculate the stock’s earnings yield you have to divide EPS by share price and multiply by 100 to turn it into percentages.

    The earnings yield of a stock is the percentage of each dollar invested in company stocky. It is calculated by dividing earnings per share of the company to its share price. 

    And as you can see, our ABC company has a low P/E ratio but high earnings yield. That will always be like this, the stock with a lower P/E ratio has a higher earnings yield, and the stock with a higher P/E ratio has a lower earnings yield. 

    This lets you easily compare the return you are earning from the underlying company’s business to other investments. Also, this will provide you to avoid to get in bubbles, panics, and fears. It gives you an insight into the stock market and directs on the underlying economic facts.

    Of course, you don’t need to perform all these math even if it is totally simple. This is especially important for beginners in the market. 

    The majority of stock market sites will automatically figure the P/E ratio and you can see it immediately. With help of this number, you can understand the difference between a stock that is selling at a high price because it suddenly became an analysts’ darling and a stable company that is out of analysts’ kindness and investors are selling it for a part of what it truly deserves.

    The two types of EPS metrics 

    Forward P/E ratio

    The most common types of P/E ratios are the forward (also known as leading) P/E and the trailing P/E.
    The forward P/E uses expected earnings guidance instead of trailing figures. It is useful when you want to compare the current earnings to the future.
    While it is helpful it also can lead you to some confusion. The main problem is that companies often underestimate earnings. The reason behind this is they want to beat the estimated P/E when they announce the next quarterly earnings. Also, some companies will declare too strong and enthusiastic the estimation but later adapt it in the next earnings report. Of course, there are always analysts to provide estimates but can confuse too.

    Trailing P/E ratio

    The trailing P/E the most popular P/E metric. It takes into account past performances. To calculate the trailing P/E you have to divide the current share price by the EPS earnings for the last 12 months. Investors mostly like trailing P/E because it is more objective.
    But this ratio also has weaknesses since the past performances don’t guarantee future performances. It is always better to invest money based on future earnings chances. 

    The other problem is the EPS figure is constant. You know the stock price is changing. If some company event pushes the stock price higher or lower, the trailing P/E will not reflective of those changes in full. The trailing P/E will alter as the price of a company’s stock moves because earnings are published each quarter. On the other side, stocks trade every day.  That’s why investors favor forward P/E. When the forward P/E ratio is lower than the trailing P/E, you can be sure the analysts are expecting earnings to increase. And vice versa.

    What are the limitations of P/E?

    The P/E ratio has some limitations. When it is low you may think the stock is good but the stock isn’t good just because it is cheap. You have to know the growth rate, free cash flow yield, dividend yield, and many other metrics also, to make a qualified decision when buying a stock.

    Build a diversified portfolio that not only holds assets that were handsome but also reduces risk.

     

  • CAPE Ratio Or The Shiller PE Ratio

    CAPE Ratio Or The Shiller PE Ratio

    CAPE Ratio Or The Shiller PE Ratio
    The CAPE ratio has some predictive ability so you can create your investment strategy based on the CAPE.

    The CAPE ratio is a variety of the P/E ratio. Just like the P/E ratio, the CAPE ratio shows whether a stock price is undervalued, overvalued, or fairly valued. 

    But, the CAPE ratio permits the evaluation of a company’s profitability during various periods of an economic cycle. The CAPE ratio also analyses economic fluctuations, both the economy’s expansion and recession. Basically, the CAPE ratio is a tool analysts use to measure how ‘cheap’ or ‘expensive’ the stock market is. We can know that only if we compare its P/E ratio with historical values over the last 10 years, that is common. And if the P/E ratio of the market is lower than it’s 10-years average we can say the market is undervalued. Hence, if the 10-years average is higher, the market is overvalued.

    This metric to estimate if the stock market is overvalued or undervalued was developed by Robert Shiller, an American Nobel Prize Laureate in economics. It became very popular during the Dotcom Bubble. At that time Shiller perfectly pointed out that equities were extremely overvalued. That’s why this metric is also called Shiller PE.

    How to calculate the CAPE ratio?

    It is possible if you divide the current market price by the 10-year average of inflation-adjusted earnings per share. 

    CAPE RATIO = PRICE / AVERAGE EARNINGS ADJUSTED FOR INFLATION

     

    That’s a big bite, so lets this formula to make a bit simpler.

    Let’s say, some farmer is selling apples for $20 each. WOW! This guy may make a fortune. But who will pay $20 for just one apple? Is it golden? Everyone would think the price is insane. But let’s take a look at historical data for the last 10 years. For example, we found one single apple has been selling at $40 over the past 10 years. This would change your opinion and we suddenly believe the price of $20 isn’t high, it is contrary, very cheap. Something different we would believe if we found the apple average price was $2 over the last 10 years. Who would buy now? 

    So, we estimated what was the average apple price in 10 years to have a comprehensive idea of how much apple costs.

    Let’s this example apply to the stock market which has a historical price called a P/E.

    P/E is when the price per share is divided by the earnings per share each year. If the farmer mentioned above started a company and makes $2 a share and the stock market values each share of the company at $10, what would the P/E ratio be? The P/E would be 5.

    Let’s use CAPE

    If the CAPE ratio is extremely high, which means that we have a company with a higher stock price than the company’s earnings show. So we would easily conclude that the stock of such a company is overvalued. Of course, we can expect that the market will ultimately correct the stock price by shifting it down to its fair value.

    How the CAPE Ratio Works 

    A good position for following the CAPE ratio is to estimate the basic P/E ratio as first. It is a generally-accepted metric, but Shiller noticed a restriction in it.

    Well, a company’s earnings can be reasonably volatile from year to year particularly during top and not so good years in a business cycle. To have accurate info about some company we have to minimize the effect of the short-term business cycle on the valuation. That was the problem that Shiller noticed. Instead of looking at just one year, he created the ratio that takes into consideration the average earnings over the past 10 years. This provides comparing valuations over a longer period of time.

    One disadvantage of the popular P/E ratio is that it is related to the past 12-months earnings only. But what if something temporary happens during that period? For instance, a big store-chain has to close some of them for restoring them. That would reduce the earning for sure but the company finished what was planned and made progress in earnings. But you didn’t buy a share of that company just because you made your decision based only on one metric – P/E ratio. And you missed the profit. By using the CAPE ratio you would be able to make a better choice.

    Ability of Forecasting

    The CAPE ratio showed its importance in recognizing possible bubbles and market crashes. It was determined that the historical average of the ratio for the S&P 500 Index was inside 15 and 16. The maximum levels of the ratio passed 30. The record-high levels occurred several times. The first was in 1929 before the Wall Street crash that flagged the Great Depression. The second occurred in the late 1990s and announced the Dotcom Crash. Also, we had signals before the 2007-2008 Financial Crisis.

    Speaking about investors and investments, there is held to be a relationship between the CAPE ratio and future earnings. Shiller noticed that lower ratios give higher returns for investors over time.

    Nevertheless, there are critiques regarding the use of the CAPE ratio in predicting earnings. The main problem is that the CAPE ratio does not calculate the moves in accounting reporting rules. For example, what if changes in the calculation of earnings under the GAAP appear? That could change the ratio and present a pessimistic sense of future earnings.

    Bottom line

    The CAPE isn’t the only metric you should use when investing but of course, it is one of. 

    It’s mostly used to the S&P 500, but can be applied to any stock index. The advantage is that it is one of several valuation metrics that can help you. It is important to find the current relationship between the price you pay for stock and future earnings. If the CAPE is high, and other measures are high, it is a good idea to cut your stock exposure. Also, you can invest in something cheaper.

    A savvy investor should always compare the price that pays and the value that gets. Regularly, all investors want to buy a company when its stock is trading at a low P/E ratio. That will give them a better profit.

    But that could be the problem too. When a recession, the stock will fall. At the same time, the company’s earnings will fall, and that can quickly raise the P/E ratio. But it is temporary. The consequence is that we are receiving a false signal that the market is expensive. And what we are doing? We don’t buy the stock when certainly it’s the best time to buy it. And here is the point where the CAPE ratio is fully useful.

    It shows a more realistic relationship between current prices and earnings based on 10-years average adjusted for inflation over the latest business cycle.

    When you are choosing which assets to sell, CAPE can be a great support. If you see that CAPE shows the S&P 500 is undervalued, sell bonds. And when CAPE shows the S&P 500 is overvalued, sell those holdings first.