We were a little concerned with his scratching his buttocks. Those butts were pathetically red and sore. Nevertheless, we thought what must be taught must be told.
So we highlighted, “But sometimes stocks with high P/E may not always necessarily be on your avoid list. And we really mean sometimes only.”
“Give me a break, guys. I’m quitting. I’d better be selling fishes. Stock evaluation is such a messy stuff! I’ve only gotten those P/Es halfway through my thick skull and now you are telling me another.” Rex grumbled, “Can't you see how red and sore my butts are now?” scratching even harder.
“Rex. Don't forget P/Es can come down when earnings improve. If a stock of 50 times P/E is poised to make 5 times more profits in the next quarter, that will bring the P/E down to 10 times. It sure sounds a lot better, doesn’t it? It happens, well sometimes, and that’s ‘if’.”
“Oh yeah! Now that’s worth my sore butts. But let's see. Am I right to say that the reverse is also true? The P/E of a stock of 5 times can shoot up to 50 times if its earnings falls from say, $1 million profit to $1hundred thousand [$100,000/$1,000,000 x 5 P/E]? And that’s ‘if’ too.” Rex grinned.
“You’ve got it pal! We’re so proud of you.” 50 times P/E may be a little extreme, but on second thought, even a stock with a thousand times P/E is still better off than one that has no P/E. As long as a stock has positive P/E, no matter how large or small the number is, it's ‘profitable’. But when the P/E is missing, it becomes ‘NM- not meaningful’; that company is surely loss-making. We thought to ourselves.
“So, P/E is the standard yardstick and can be used to make forecasts...” scratched and scratching, “but what if there’s no profit? I mean if a company makes losses instead. There’s no P/E, or ‘negative P/E, does the price go all the way down to zero?” Rex asked.
“Whoa! Was our thinking that loud? We were just thinking about that.” Now we scratched too, our heads. Anyway, here’s when NAV [Net Asset value] is important. It's a good question you’ve asked. Typically, the NAV/per share serves as the stock price ‘cushion’ when a company starts making losses. Empirically, stocks usually trade above 80% NAV even when they are making operational losses. This is because that’s the ‘least’ the company is worth. It is the potential value the shareholders can get in times of liquidation [after preferred shareholders] or winding –up. Perhaps why there’s a discount of 20% off the NAV when their earnings are in red is because in the real economic market, you don't usually get what you say your assets are worth. This is especially true when you need to sell badly. Therefore, the 20% serves as an allowance for mark down and some contingent write-offs. If a stock trades way too low from its NAV, some rich smart guy will attempt to buy over the controlling stake of the company and strip it into parts for sale and gets to keep the change. That would be sad for everyone else. But a stock may sometimes [rare] go way below NAV by as much as 50%, in this case, the stock is either held by the big majority and therefore no one can acquire a controlling stake, or the market is just not taking what they claim their assets are worth. So, first, a stock is worth at least 80% of its NAV which is the buffer price. Next, if the P/E is within the industry’s average, the market will take whichever is higher.”
“So remember, the next time you look at stock price, this is what you should say: ‘The stock won't be able to hold at the current 16 times, I see 12 times for now.’. Work out the price and sell. The challenge, however, is on your sense of pricing acumen. As a pointer, you should refer to the historical P/E range of the stock to conjecture the ‘appropriate’ pricing. If you can do it with properties, you can do the same on stocks. Just give a shot at giving a P/E value to a stock as close to what the fundmanagers have on mind; you’ll be surprised with how realistic it is and how close you can get with this method of evaluating and making forecasts on stock
So that was how our friend worked out the numbers also? Instead of using guts feel on price, he made assumption on the stock’s P/E?” Rex checked to make sure he’s following correctly.
“Yes. Sure as fish is fish, Rex. You got it. But to make sure you really really really got it, here’s a list of stocks for you to practice on making forecasts:
“Look Rex. It might sound like a lot for you to digest in a go. But your ability to profit from trading and investment ultimately depends on the price you pay for a stock. Buying a good stock or good story only forms part of the winning equation; buying it at the good price is more important. Making adjustments on the P/Es becomes more of a science than art once you get the hang of it. You’ll be surprised at how close P/E forecasts can get you with a lot more insights than mere guts feel.”
---end of chapter 3----
In the coming posts [but randomly], I will discuss a relevant concept known as IMPLIED GROWTH model and how can we use it to double check the 'fairness' of a P/E status/level of a stock. i.e P/E too high or low or reasonable. The equation can be reversed to look at what the current P/E implies or assumes of a company's growth prospect [y-o-y growth in percentage] and then tallied against the historical /projected earnings performance to 'judge' if the current P/E valuation is justifiable/realistic. Quite an interesting and useful check tool.
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