StockRats now explain: how to evaluate stocks and make your own desktop forecasts...
“Hey guys! Good lord I found you!” Rex said excitedly. “Do you have time today? I mean now?”
“Yeah, but why? You seem to be in some sort of a hurry. What’s the deal?” We asked.
“I am rushing to meet my property agent to place my downpayment for an apartment. Quick! Come with me. I’ve asked him to reserve a unit for you too. Lets get going! ...and don’t forget your cheque!”
“Wait Rex. What apartment?”
“Sssshhh! Do be so loud. Come over here...” Rex whispered as he shoved us to a corner, "...you know my boss? That fellow has recently flipped over two units for a cool profit quietly. He’s such a selfish. But fortunately I overheard him reporting to his wife. He seemed to have made some few hundred thousands from the property market. And I heard him telling his wife that he’s going for another unit in the downtown."
“Guess what! I managed to get hold of the agent’s contact. After hours of my persuading, he finally agreed to reserve the last two units for us... if we would pay a deposit today...now. That’s why I am rushing. One’s for me, and one’s for you guys. Lets go!”
“Hold your horse Rex. Why are you buying a property at this time?” We prompted.
“What! Don’t you know that the property market is sizzling hot now? What could be a better time than now? Can't hold for long StockRats, I’ve got you a good price. We’d better be going before the agent back out!”
“Wait Rex, how good is good price?”
“Don't worry StockRats, I did my homework.” Proudly he claimed, “I’ve checked with my banker. He said the property is valued at $1,000,000/- (one million dollars). And you know what? We are buying at $950,000. That’s what I call good price.”
“Rex, it's good that you have verified. True enough that the price you’ve gotten for the apartment may be $50,000 cheaper, but not necessarily cheap. It doesn’t tell you much about the price."
“Let us give you an example. At $10/- per share, is a stock cheap or expensive? Now, suppose I evaluate the stock price in the same way as you did; the stock has fallen to $9.50 per share. It’s cheaper by 50 cents per share, but can you tell if the stock is intrinsically cheap or expensive?”
“Errr....” said Rex, scratching his buttocks.
“Lets talk about P/E ratio.”
“P/E? Price per share divided by earnings per share. Come’on, that’s fifth grade maths. Everybody knows that. The lower the ratio, the cheaper the stock is, right?”
“So, can you tell me what it means when say... a stock has a P/E of 10 times and another 20 times?” we asked him.
Rex: “Simple! The stock with 20 times P/E is twice as expensive as the one with 10 times.”
“Ummm...lets see. Our point about P/E might twist your mind a little. We are going to tell you that you don’t and you can't simply use P/E to compare stock to stock. We know you always get comparative reports from analysts who like to present a table of stocks of the similar industry. They will tell you that a certain stock is cheaper than its peer using the P/E. And that’s the problem when you learn to do the same. It is ‘useful’ for someone who wishes to sell the stock to the public, not for someone who wants to buy the stock. You need to understand that no doubt they may be from the same industry, their financials, Net Asset Value (NAV), managements, goodwill, customers, strategies, future prospects and most elements are quite different when you take a closer look. When you believe that stocks can be compared in this manner, you are actually comparing a house which is renovated and well-furnished with one that is not. I am sure you would not pay the same price even if they are in the same district, would you? That’s why stocks carry different P/E valuations even though they belong to the same industry. And that’s what the market professionals clearly see that the average investors don’t."
“But how could it be different when we are using the same yardstick? I mean we are referring to the same bottom line – earnings. So when we say Stock A has 3 times P/E and Stock B has 3 times P/E too, aren't they doing their shareholders the same favour?’
“Well yes, but only on the surface of it. Let's consider your example. What if Stock A makes $3 million a year but Stock B makes $30 million a year? They still can have the same P/E of 3 times, can't they? Now tell me which is a better company? Will you still want to put them together for comparison? What if both Stock A and Stock B make $3 million, BUT Stock A has a higher NAV than Stock B? Are they still comparable?”
“Oh hell with it! I just bought a stock my broker recommended on this very basis. What should I do now?” Rex got panicky.
“Don’t worry about it Rex. It’s going to be fine. There will be people who are willingly to buy the story. But you need to exit as soon as the market starts biting on the report. You don’t want to be caught believing that the stock is hence undervalued and its price will start moving because its P/E valuation will match its peers. It might do so, but it will not be able to hold and sustain at the price level for long because the big players know that’s just not the way to use P/Es. Remember Rule #4? Flirt with good stories but marry only good stocks? That’s a pretty good ‘story’ that most novices bite on. You just need to sell along to those who use P/Es in the wrong way.”
“Now we ask you another question. Is a stock trading at $1.00 per share cheaper or a stock that’s trading at $10 per share cheaper?”
Rex: “Is this a maths class or what? I am starting to get a headache with your trick questions.”
StockRats: “Well then, we’ll answer that for you. We don't know...unless...”
“What!” Rex’s eyes rolled back and started twitching as if he was fainting.
“...unless and until we look at the total number of shares issued by the company and multiple it by its stock price. You’ll get something called the market capitalisation or ‘market cap’ for short. That will give you a better idea. But most people would just take as read. It’s a straightforward to them that a stock trading at $10/- is a bigger or better company. And the $1/- stock is a smaller or cheaper stock. That’s a common fallacy. Let's look at a real case study. Two years back, a stock which was trading at $0.15 per share caught our attention. But its earnings report surprised us quite a bit. It was ranked among the top ten earners listed on the exchange in terms of net profit after tax (NPAT). Despite its teeny stock price, the company actually churned out earnings on par with some of the blue chips which were trading way above five dollars per share on the average. All we did was checking out its outstanding shares. That confirmed our suspicion on why the stock was trading at that low. The huge number of stock issued diluted its earnings and price per share. We knew at the instant that we found an unpolished gem. And the most wonderful part was we could buy by the millions shares because of the low price denomination. Six months later, the company announced a reverse split (share consolidation) of 10:1. That means that our holdings shrunk from every ten shares to one. But that’s not all bad news at all. In fact, the moment that was announced, the market realised that it was no small company actually because the stock quote was now $1.50 per share. Along with a lovely story of a special dividend payout, the stock price rocketed to $3.80 per share in just one month. The moral of this story is that looking at price alone can be quite delusive; one must learn to look beyond the price tag if you don't want to mess up the truly cheap and the expensive.”
“So StockRats, what would be the correct way to use P/E and how should I use it?”
Stayed tuned for more...
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