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The High Price of Price to Earnings Editor’s Note: Today, our newest contributor, Jonas Elmerraji, is back to explain why P/E ratios are always what they’re cracked up to be. Most new investors just don’t get it. Jonas explains… How Newbies Pick Stocks
A Valuable Tool for Measuring Value The price-to-earnings ratio is one of the most well-known — and maybe misunderstood — metrics that investors can use to look at how much a company is worth. The P/E ratio is calculated by taking a company’s market capitalization and dividing that by its net income. Basically, it’s a multiple that tells you how much investors are paying for that company’s net income. ************************************ 25,498% in Just Six Months Jumper: n. — An unknown micro-cap stock that's destined for a transition to a major exchange after a period of steady — or explosive — growth in an overlooked segment of the market. On Tuesday this week, we had one tiny company jump… This is only the third day, and we’re up 22%. Get in before it really shoots up. Check it out here… ************************************ But remember, P/E ratios vary from industry to industry — while American Express’s P/E is somewhere around 13 right now, it doesn’t make sense to say that it’s any cheaper (or more undervalued) than Apple, which has a higher P/E of 33. They’re in different industries, so you can expect very different P/Es. With that little nugget in mind, it’s easy to fall into the trap of thinking that P/E ratios are the end-all be-all for stock valuation. Granted, it’s a valuable tool for measuring value, but there are also some things you should keep in mind about a company’s P/E. When P/E Becomes Pricey So, what do you need to know about P/E ratios? Well, for one, consider the fact that a stock’s market price comes into play in a big way with P/E ratios. A higher stock price means a higher P/E ratio, and vise versa. When P/Es are low (compared to the industry or a historical P/E), investors are prone to think that it’s a sign that they’ve got a bargain on their hands. But why might that number be low? For one, you might see a company’s P/E ratio drop when investors don’t think that its stock is worth what it used to be. That’s what happened to OFSI, a banking company that’s banking on some “substantial” losses this year. OFSI’s P/E is sitting around 2, while others in their industry are sitting pretty with double-digit P/E numbers. Another concern with the price to earnings ratio is the fact that “earnings” doesn’t always mean “how much money we made”… ************************************ The Single Secret Behind The Most Profitable Trade of All Time... When a Hungarian banker did this, he made $1.1 billion in 24 hours...when three young Wall Street traders did this, they hauled in $4 billion... And just last year, one man used this secret strategy to make an average of nearly $11 million per day…here’s what you need to do the same… ************************************ Companies report income according to Generally Accepted Accounting Principles (GAAP). Because non-cash items can affect a company’s earnings in a big way, the P/E isn’t always an accurate read on valuation. Penny stocks are often the hardest hit by P/E manipulations. That’s because penny stocks tend to see more fluctuations in price (the “P” in “P/E”) than blue chips like Wal-Mart and Exxon-Mobil. Don’t Give Up on P/E Now, don’t get me wrong… I’m definitely not saying that you should toss the price-to-earnings ratio. Like I said before, the P/E ratio is one of the most valuable tools investors have for determining a company’s value. What I am saying is that the P/E ratio should be used in concert with other metrics to get a better picture of how much a company’s worth. Using other fundamentals like dividend yield (if the company pays a dividend), enterprise value, PEG ratio, and price-to-cash flow can help you get the whole picture on a stock’s prospects. We’ll give you more insight into these tools in the coming weeks. You don’t have to be Warren Buffet to learn how to value companies effectively. What you do need is a solid understanding of how valuation ratios like P/E work, shortcomings and all. Cheers, P.S.: Penny Sleuth contributors Greg Guenthner and Jim Nelson have just uncovered two penny stocks with perfect financials. They just told readers about them Monday…now’s your chance to get in! If you want a piece of the action, click here. |
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