“We’re glad you’re asking. You can also use P/Es to make your own simple price projections and forecasts, especially when you need an answer fast. ”
“Wow! Sounds like some witchcraft to me. You know the crystal balls thingy that we see in the movies? Do we need one of those?
I’ve got one big ball in my fish tank, will that do the trick? Or do you sell them?”
“Rex, what we’re going to share with you is no witchcraft but an extremely simplified method for non-financial. It’s a DIY version; a home edition. If you can count 1 to 10 backwards, you can do it. Though simple, it's really useful when you need to set your buying or selling price targets. In fact, it has helped us made some great judgment calls. But you must understand that all forecasts can only be as close as getting the highest possibilities of outcome because the grounds of forecasts are always based on a set of assumptions.
The merit of using P/Es as a tool for forecasting is that it overcomes what most people otherwise depend on- guts feel or guesstimations. Let’s take the recent Subprime Crisis for example. Someone we know had a few stocks in hand and didn’t know what to do when the bad news started hitting the market. One of his stocks was then trading at around $3.20 per share. He was caught quite in a dilemma between taking losses and worrying that the stock might fall further. Yet again, he wondered if it would be worthwhile to take the risk to sell the stock and buy back later. The big question was how much the stock would fall, or would it even fall at all? Besides, the stock was already at low P/E of about 4 times at $3.20/-. But a decision must be made. When faced with a fix like this, most people would just keep their fingers crossed, hang on and pray hard. Now this is a classic example on the difference between using guts-feel or guesstimations versus P/E forecasts.”
“Oh, just sell everything and buy them back cheaper later.” Rex remarked.
“Good point there, Rex. But what price would you buy them back if you were in his shoes?”
“Let’s see...” scratching his buttocks again. That’s something we love watching whenever our friend uses his brain. Give him a couple of teasers and he will do that for you.
“My sixth sense tells me $2.80/- will be bad enough, or no, maybe $2.50? But $2.20 seems quite possible too, or is it too aggressive? Hmmm...” He went scratch and scratching.
“Rex. The stock fell more than half to $1.54 per share in no more than a month. That really happened. It's a true incident, and it's a very recent one in fact.”
“What! That’s a cut throat! Good dolphins! What happened to your friend?”
“No harm done. He’s fine. He managed to escape the fall and saved his fat ass.”
“Wowee! How did he do that? How could he have imagined the price would fall that bad? That’s a cool foresight!” Rex was amazed.
“Rex. You can do the same. Not with guts feel or some magical foresight, but a simple desktop calculation will just do the trick well. Really simple; like you said- fifth grade maths. You don't have to be a qualified accountant or super analyst. It’s 80% fifth grade mathematics and 20% street-man assumptions...”
“Note that instead of guessing how much the price would fall which is rather difficult, we made an assumption on the P/E instead. We guessed that it would fall from 4 to 2 times. What was more important was when we did the calculations for him; he could instantly see the huge downside possibility which helped him decisively sold the stocks quick. Let's look at the maths:
“Can you see how a seemingly small shift in P/E can have such a big impact on the stock price? Can you see the difference between using P/E to make projections and guts feel? If we were looking at price alone, we wouldn't have imagined the price could fall that bad. Your guess of $2.20 is still a far cry and you thought it was too aggressive to expect that. But the maths clearly tells us that $1.60 was realistic and very possible. That’s how the forecasting was done. Simple?”
“So that was how your friend worked out the numbers. Instead of using guts feel on price, he made an assumption on the stock’s P/E? But why did he choose 2 times? Not 3, not 2.5, not 0.8 or whatever? I don't understand.” Rex checked to make sure he was following correctly.
“That’s because the stock has had a record low of trading at 1.54 times P/E, and the Subprime Mortgage was a big bad news. Honestly, no one knows how badly businesses will be affected, not until the actual reports are out. We only know it’s bad. But you can't afford to wait. So we’ve got to anticipate. Even if we were wrong about the business being affected, assuming that the results turned out to be alright, we were sure we would be right about a ‘devaluation’ phase that was beginning to place across the market. It happens when the market is losing confidence and the economy is beginning to contract after years of expansion. It always happens; like a ritual; something which the academics and pros prefer to call it cycles. It’s a ritual nonetheless.”
“What’s devaluation? Ouch!” scratch, scratched.
“We need to use the property market to explain that; it’s easier to appreciate. Say a prime property in the downtown. During a good market, a developer can easily fetch $2,000/psf and a landlord can rent it out for $10,000/mth. However, in bad times, the exact same property may only sell for $1,500/psf and the rental goes down to $8,000/mth. And it will continue to fall to $1,200/psf and so on and so on until the real economy or at least the perceptions of it [sentiment] improve. The same is true with stocks. Earnings and everything else may remain the same, but the gloomy economic outlook or actual conditions can pull down the valuations of stocks just like properties. P/E is the basic fundamental valuation yardstick for stock; the equivalent of how psf [per square foot] or psm [per square metre] is used as pricing metric for properties.”
“Consider a fresh IPO [Initial Public Offering] listing for the case. The duration for the preparation work from conception to eligibility for application for listing approval can take as long as 2- 3 years. However, even as a company may be all ready to go for listing after all the efforts, its IPO manager may advise against it and seek postponement when such timing coincides with a bad market condition. That’s because the IPO managers know that market conditions affect valuations. And the valuation is again based on P/Es. The better the market condition, the higher the valuation [P/E], the more funds they can raise [good] the more the public pays for the shares [bad]. They can't simply say: let's issue at $3/- or $4/- or $20/-. Having considered the market conditions and the ‘storyline’, only P/E will tell them whether the stock is price in or out of market. They say; “it’s in our opinion that a P/E of 6 times is the maximum we can try in this market condition and for your type of business. We need to give the market some margin too. If we place it at any higher P/E, you’ll have to pay more underwriting fees for the IPO exercise, and worse is that your stocks become undersubscribed. That would be a big boo-boo. Besides, the fundmanagers we have spoken to aren't going to take any higher than 6 times.” Once they are decided on the P/E, they then work out how much the stock is to be priced based on that P/E. not the other way where you decide the price first then work backwards to get the P/E. If they want to make the stock ‘affordable’, they increase the number of shares to be issued instead. When more shares are issued, the earnings are diluted accordingly; therefore the stock price per share becomes lower, but the P/E remains the same.”
Rex: "I see!"
"Okay, now tell us, a stock has fallen from $50/- to $25/- , are you able to tell if it's cheap or expensive?”
“Of course I can! That’s an obvious 50% discount! Quick tell me which stock is it. Let me call my broker now. Tell me the truth, how many of these opportunities have you been keeping to yourselves?”
“Rex. you are looking at price too ‘technically’. A common mistake with most people when it comes to hunting for 'cheap' stocks; they are so used to looking at price per share alone, literally; they become technical people although they may not necessarily believe in charting; not that they are not aware of such a thing called P/E ratio, but perhaps they forgot. You wouldn't know it's valuation without P/E, intrinsically. And it's difficult to imagine a stock to fall that much; not without P/E. Can you see how useful it is now? ”
“StockRats, I hope you wouldn't mind my bluntness, but who cares about P/Es? I mean as long as the stocks I buy can move and make me money, why bother about ‘pricing valuation?”
“Fair proposition, Rex. What you’ve said is very true. The high often goes higher. And if you know how to flirt with stories as we have taught you in the first chapter on stock selection, fine. Go ahead, really. But are you one of those who know when to call it quit? Are you disciplined enough to control your emotions, your greed? If you don't have that, it's enough of detriments you have as an investor or trader already. Please do not develop another self-sabotaging mentality.When you choose to ignore value and play the musical chair game, chasing after hot stocks, you will never beat the market at it. And they sure love customers like you. Go gambling in the casino if you really like that, because I bet you that your chances are much much better there. P/E is like a rubber band when a company cannot support it with earnings, earnings earnings. There’s a limit that you can stretch one. If you pull it too hard and when it snaps on your fingers, it's gonna hurt you bad. P/Es MUST be supported by either historical or projected earnings..”
“Okay. But it really really sounds too simple to be true. Are you sure this is an appropriate way? No offense, but I do have some doubts about your so-called simplified method...it just doesn't sound 'pro' you know?"
"Honestly, when we discovered this simple method, we had doubts too. But it has proven to serve us well even in pressing situations. As long as we can arrive at the same destination, time after time, it really doesn't matter whether you came in a car, taxi or bus. And for your peace of mind, we have spoken and verified with some industry analysts; they have no hesitation in acknowledging it as an applicable and mathematically logical desktop forecasting method minus all the complexity. BUT, There’s an exception to it.”"
“What? More?"
Stay tuned for more...
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