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Financial Literacy

Determine Stocks’ True Values Using This Simple Metric

On Sunday, my wife and I went to the farmer’s market. We picked up a small batch of olive oil that we like and some pumpkins for Halloween.

But I’ll be honest… those weren’t the real reasons I wanted to go.

No, the real reason is that a local pie company owned by a Food Network alum has a booth there. And I really love the pies.

Even better, I know that a whole pie costs significantly less at the farmer’s market – $25 – versus going to one of the company’s shops in D.C. or Baltimore where I would spend $30.

Or I can buy a big wedge slice for $5, which is also a discount compared to the store price. (Obviously, the whole pie is the best value. But sometimes, I just can’t trust myself with an entire pie.)

As an added bonus, going to the farmer’s market instead of traveling into Chinatown or Northeast D.C. saves me a 30-minute drive.

The point I’m trying to make is this…

At our heart, so many of us are bargain hunters. We buy marked-down items from the supermarket and clothing outlets. Clearance sales draw us in like moths to a flame.

But as investors, it’s important that we know and understand the difference between temporarily undervalued shares and those that are permanently in decline.

Today, I’m going to share a unique technique I use to determine the value of high-growth opportunities. It starts with price-to-earnings (P/E) ratios…

“What’s an Ideal P/E Ratio?”

A lot of investors make noise over P/E. I’ve listened to folks complain that they won’t buy shares of a certain company because its P/E ratio is too high. In their view, it means shares are way overvalued. But that’s not quite right.

To begin, a company’s P/E ratio is backward-looking. You’re looking at how the shares are priced compared to its performance over the last 12 months.

However, the market is forward-looking. This is why a company can beat on earnings but shares get pummeled on guidance.

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The past is the past. The future is what’s important.

Beyond this, some sectors simply have low P/Es (like utilities). Others have high ones (like technology stocks). There is no “perfect” P/E ratio. Yet it’s a question I get often… “What’s an ideal P/E ratio?”

My answer? “It depends.”

Benjamin Graham and Warren Buffett abide by this formula: The ideal P/E multiple equals “8.5 times earnings plus two times the growth rate of earnings.”

Others claim investors should buy only stocks with a P/E lower than 8.0 because they’ll provide the best returns over the next 12 months. Some examples of sub-8.0 stocks:

  • American Airlines (Nasdaq: AAL) – 4.02
  • Ford (NYSE: F) – 5.56
  • General Motors (NYSE: GM) – 4.05
  • HP (NYSE: HPQ) – 7.4
  • GameStop (NYSE: GME) – 6.56
  • Office Depot (Nasdaq: ODP) – 6.57.

This strategy is pretty much akin to buying the “Dogs of the Dow.” They’re the worst-performing blue chips and stocks. The idea is that they’ll rise over the next year because things can’t get any worse.

Maybe some of those companies will have a better 2017. Then again, maybe some of them are heading the way of Blockbuster and RadioShack.

For me, because P/Es are industry-specific, you have to dig a little deeper to determine value and true growth.

You have to…

  • Look at the company’s P/E ratio compared to its peers.
  • Look at that P/E ratio compared to its forward P/E.
  • Look at its P/E compared to its historical P/E.

My first rule of thumb: If the forward P/E is higher than the current P/E, avoid the company. Because what that means is shares are “more expensive” currently, compared to future growth.

For example…

Why the Big Picture Matters

Let’s look at Amazon (Nasdaq: AMZN). The company’s current P/E is 205.56. You might look at that and say, “Shares are overpriced!” It’s even more shocking when you consider they are just off their 52-week high of $847.21.

But you have to look at the big picture. Last year, Amazon’s P/E was 463.73. In 2013, it was 601.22. You have to go back to 2011 to find a sub-200 P/E for Amazon.

So the company’s current P/E of 205.56 isn’t bad compared to its historic P/E.

And its forward P/E is 75.21. That difference between P/E and forward P/E tells you how much earnings are expected to grow. It’s something I really take into account. Often, the bigger disparity between current P/E and forward P/E, the more I like a company.

That means its profitability is expected to surge.

Just food for thought… In its last quarterly report, Amazon’s earnings per share (EPS) increased 831% as revenue grew more than 31%. Full-year EPS is expected to grow from $5.85 this year to $10.99 next year.

Amazon is interesting because we can throw it into several categories, but we’ll use retail for today’s comparison. Let’s look at Wal-Mart (NYSE: WMT).

Currently, it has a P/E of 14.93. Investors love those low P/Es. It seems like a value. And with shares trading just a couple percentage points above its 52-week low of $67, investors might see it as a “steal” at current prices.

But Wal-Mart’s forward P/E is 15.91.

In its most recent quarter, Wal-Mart’s revenue increased 0.50%, while EPS increased 8.60%. And EPS is projected to increase from $4.34 in 2016 to $4.36 in 2017 as revenue inches up 2.4%.

That’s not very impressive, is it? The devil is always in the details.

A valuation metric like P/E can’t be used as an end-all analysis. Like everything else, it’s just one slice of a larger pie you have to take into consideration.

I wouldn’t buy shares of Wal-Mart, Office Depot, GameStop or Bed Bath & Beyond (Nasdaq: BBBY) over Amazon just because of their lower P/E ratios. Their growth prospects aren’t that exciting to me.

We always have to take into account the bigger picture. It requires some work, but believe me… it’s well worth it.

I’m not alone on this, either. In tomorrow’s issue, Alexander Green will discuss the importance of knowing a stock’s true worth… and the dangers of falling into the “value trap.” Stay tuned.

Good investing,

Matthew


About

Matthew’s expertise ranges from classic industries such as oil and mining to cutting-edge markets like small cap tech, cannabis, 3D printing and cloud computing. With almost two decades of financial experience under his belt, Matthew’s knack for finding market trends never fails to surprise us, which is why we keep a close eye on his free e-letter, Profit Trends.

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