Archive for January, 2009
Friday, January 30th, 2009
In our prior post (The P/E Ratio Explained Part I) we discussed the various methods of calculating the P/E ratio. However, what does it mean conceptually? Essentially, the P/E should tell you how expensive a stock is based on the earnings of the company.
An Example
Let’s say you are presented with 2 choices. You have 2 friends that have businesses making running shoes. They have both been in business about 5 years, and both businesses make $1,000 in profit per year (ok, so they are really small businesses). In addition, both businesses are offering to sell shares of the business to their friends. Friend A is selling 200 shares for $10 a share, and Friend B is selling 500 shares for $5 a share. Which is really a better deal? Let’s keep it basic and not consider the concept of present value for now.
Friend A is selling 200 shares, so let’s figure his earnings per share (EPS). We do this by simply dividing earnings (this is the profit of $1,000 per year) by 200 shares = $1,000 / 200 = $5 per share. So, the P/E is:
P/E = $10 per share / $5 per share = 2.0
How about friend B? We do the same thing - Friend B is selling 500 shares so the earnings per share (EPS) = $1,000 / 500 = $2 per share and the P/E is:
P/E = $5 per share / $2 per share =2.5
So this tells us (in theory) that Friend A’s offer is slightly better - since investors pay less for a share of stock relative to future earnings.
Posted in Investing, Stock Basics, Stock Metrics | No Comments »
Monday, January 26th, 2009
While the economy hovers in a holding pattern of uncertainty - I think it’s a good idea to get back to basics and really understand some of the fundamentals of stocks. So, let’s start with the metric most investors are familiar with: the P/E ratio.
The P/E Ratio Explained
In a nutshell, the P/E is simply the price of a stock per share divided by earnings per share (also called “EPS”). However, keep in mind that the way the P/E is calculated depends on what period of time you are looking at.
The “Current” P/E
The “current” P/E is the most basic variation of the P/E. It is simply the current market price divided by the most recent annual earnings per share (such as full year 2008 earnings for a company).
The “Trailing” P/E
If you look up a quote for Exxon Mobil on Yahoo Finance, the summary that is returned shows “P/E (ttm)“. This means the current market price is divided by “trailing twelve month” earnings per share. Essentially, you are taking the current stock price and looking backward at earnings for 4 quarters. Since earnings are reported quarterly, in April ‘09 you would divide the current price by earnings per share for Q2 ‘08 through Q2 ‘09 combined. Why? This gives you a more recent earnings benchmark to use for valuation.
The “Forward” P/E
Last but not least is the “forward” P/E - which tends to be the most controversial variation of the metric. Why? Well, because it is essentially using forecasted earnings for the next financial year in the denominator. Investors should consider the calculation of the forward P/E very carefully, as certain assumptions made by the analyst calculating the numbers can greatly affect this number. As a general rule, it is best to be conservative and underestimate earnings rather than overestimate them.
Posted in Stock Basics, Stock Metrics | No Comments »
Sunday, January 18th, 2009
What a year 2008 was. The subprime mortgage crisis and ensuing “credit crunch”, having emerged as an ominous fledgling snowball in 2007, grew into a full fledged avalanche that mercilessly bulldozed the US and global markets. So things have to get better in 2009, right? Well…maybe.
Off to a Rough Start
Right out of the gate, we were off to a rough start in the US. According to Business Week, at the end of ‘08 US markets were over 50% lower than their highs in 2007, and investors had almost 40% of fund assets in defensive money market investments. Barron’s noted that Large Cap stocks had the worst 10 year trailing returns since 1827, and returns on equities vs. bonds were the worst since the 1970s. Good times - so now what?
“Improvement” is a Relative Term
Analysts believe that, if there is an improvement in the markets in ‘09, it will be minor. The Wall Street Journal Economic Forecasting Survey predicts Gross Domestic Product (GDP) to fall 0.3% this year due to a slow 1st and 2nd quarter. In addition, unemployment is expected to rise to a whopping 9% by year end.
However, Q3 and Q4 are expected to show signs of recovery, with GDP growth rising to about 2% in the fourth quarter of 2009. Further, the US stock market may actually end the year on the upside. Both Barron’s and Business Week have featured analysis (from solid sources) that suggests the S&P 500 could close out 2009 at levels between 1000 to 1200 (that’s about 18% higher than current levels).
So, what to do? As you know, nothing is a sure thing - stick to your long term plan, stay diversified and ignore the talking heads on the financial networks. Use this “down” time to educate and improve yourself - I think this is our best bet right now.
Posted in The Stock Market | No Comments »
