Tag: PE ratio

  • Value Investing Tools That Every Investor Must Use

    Value Investing Tools That Every Investor Must Use

    Value Investing Tools That Every Investor Must Use
    “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham

    To find accurate value investing tools you’ll need time, a lot of it to do your homework. Finding the right tools requires a lot of research. It is the same as finding a good value stock to invest in. It can be so complicated that many investors are scared of all that job. 

    But if you don’t like to do your own research, here are some tricks to help you. 

    By having the value investing tools to value a company and evaluate its prospects, you can eliminate unsuitable stocks. Also, you can do it more quickly and focus on the best picks. One of the most accurate among value investing tools is the P/E ratio. 

    P/E ratios as value investing tools 

    The price-earnings ratio or P/E ratio is classified as a primary tool to identify undervalued or cheap stock. It is a simple metric that is easy to calculate. All you have to do is to divide a stock’s price per share by its earnings per share. Earnings per share is shortly expressed as EPS. Value investors always have the P/E ratio in their value investing tools boxes and seek a low P/E ratio. A lower ratio means that they will pay less per each dollar of the company’s current earnings.

    But this metric has some downsides. Of course, it is still a good start but if you rely on this one measure solely it is more likely your strategy will not be accurate and successful. 

    Investors are frequently attracted by low P/E ratio stocks. The problem is that they can be inaccurate and inflated numbers. Sometimes, companies report incorrectly high earnings sums or some forecasts show much higher earnings, so the low P/E ratio can be false. Everything becomes more clear after real earnings reports and the P/E ratio goes up and investors’ research result is false too.

    So, if you use the P/E ratio alone you’ll end up trapped with the wrong decision.

    Use PEG ratios as value investing tools

    If the P/E ratio is flawed, what should you do to find true value stocks? Which one of the value investing tools you have to use? PEG ratio will help you to recognize if a company with earnings growth is trading below its intrinsic value. The price-to-earnings ratio or PEG ratio can help you to avoid some traps while searching for value stocks. To calculate the PEG ratio use this formula:

    PEG Ratio = Price To Earnings Ratio / Earnings Growth Rate

    If the PEG ratio is less than 1 it is supposed to be a sign of an undervalued stock and it is possible to buy such stock at discount. So, the PEG ratio of 1 means the company is correctly valued. Contrary, if the PEG ratio is above 1 it may indicate that a stock is too expensive. But the PEG ratio shouldn’t be used as an individual metric. The valuation puzzle requires using other value investing tools to have a comprehensive picture of the stock’s value. 

    For many investors, the PEG ratio is a favorite among value investing tools due to its ability to show the stock that is at discount. However, as with all of the value investing tools the PEG ratio is useful to recognize the stock that could deserve a closer look. You’ll need more research and tools to reveal the possibility that the stock is cheap for a reason, in which case it isn’t the right choice. Simply, you wouldn’t want such stock in your investment portfolios.

    But keep in mind, for example, various industries will have different PEG ratios. So be careful when judging the company’s value.

    The company’s cash flow

    The company is worth only the amount of the future cash flows it can make from its operations. Keep this in mind. The value investors will always check the company’s cash flow before starting to invest. 

    As we noticed above, the P/E ratio is by no means a complete measure. The company’s net income is only an accounting entry and it is often influenced by numerous non-cash costs, for example, by depreciation. Also, companies use tricks to misrepresent their earnings. As a difference, cash flows measure the real money that the companies paid out or acquired over a given period. 

    Cash flows exclude the influence of non-cash accounting charges. They don’t include depreciation or amortization. So they are more objective value investing tools because they only admit the real cash that flows into or out of a company. Cash flows are a clear picture of the company’s real profitability. However, we have to repeat, it makes no sense to estimate cash flows as the only tool you use when seeking the value investment. 

    Enterprise value

    It is important to compare operating cash flow to the company’s Enterprise Value if you want a clearer picture of the amount of cash the business is generating related to its total value.

    To explain the enterprise value. 

    It is as a number that in theory outlines the full cost of a company if someone buys 100% of it. If the company is publicly-traded, this means buying up every single of the company’s shares.

    To calculate it you have to sum up the company’s market capitalization, add debt, preferred stock together, and subtract out the company’s cash balance. The result will show how much money an investor or group of them would need to buy the whole company. So, it is an outstanding picture of the total value of the company.
    When you divide a company’s operating cash flow by its enterprise value, you can easily calculate the company’s operating cash flow yield. 

    These measures are also the value investing tools. Especially cash flow yield because it presents the amount of cash that the company generates per year in comparison to the total value investors invested in the company.

    Return-on-Equity – ROE is excellent for value investing tool

    ROE is another excellent tool that can help you to find value stocks.  

    It is a profitability ratio and measures the ability of a company to generate profits from its shareholders’ investments. To put it simpler, the ROE shows how much profit generates each dollar of stockholders’ investment generates.
    The ROE of 1 indicates that every dollar of stockholders’ investments generates 1 dollar of net income. This measure shows how efficiently a company uses investors’ equity to generate net income.

    ROE is also an indicator of how efficient management is.

    The formula is 

    ROE = Net Income / Shareholders’ equity

    This measure is broadly used, and it is easy to find the ROE lists for publicly traded companies on almost all financial websites. When investors look for value investment opportunities, they are looking to find a stable or growing ROE of the company. 

    However, there are some cautions. For example, some companies can produce enormous ROE in one year, but the next one or more years later resulted in reduced profitability.

    Also, the tricky part is the relationship between ROE and debt. For example, if the company is taking higher debt loads it is possible to use debt capital instead of equity capital. Such a company will have a higher ROE. These companies with exponential and fast growth can be favorable, but also, can ruin shareholder value. Investors prefer ROE at around the average of the S&P 500. 

    Bottom line

    Sadly, there’s no fixed method that will provide investors a distinct way to reveal the best value stock for investing. Investors have to take into consideration the company’s sector and industry, also, if the company has an advantage over its peers. Look for the companies that are able to become brands, or have some unique product, the new technology, in other words, with a sustainable competitive advantage. 

    Remember, some companies operate in a cyclical market. For example, automakers. Such companies will have great growth and huge returns in periods of the rising economy but they will fail if the economy is in a slowdown. So think about the company’s profitability under all conditions. 

    These value investing tools will help you to uncover plenty of potential picks and to find a good stock to invest with trust.

  • 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.

     

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