This Investing Guru Just Revealed an Invaluable Secret!
“Is this stock cheap right now or is it still a little too expensive?” That’s a common question among investors. And to answer this question you need to turn to the discipline of valuation. How do you value a stock based in its earnings? How do you value a stock like Warren Buffett? Well, the mother of all valuation approaches, that’s probably the PE ratio. At least the PE ratio is the most commonly talked about approach to determine whether a company is expensive or cheap. When you turn on CNBC, for example, you can be certain that the PE multiple will be mentioned within minutes.
But in this video, I’ll show you with the help of a book from a fairly unknown investing guru how one magic ingredient can turn an expensive-looking stock on a PE ratio basis into a bargain opportunity and why there is a general tendency of stock markets to underprice quality companies.
First, I’ll just very briefly explain what the PE-ratio is actually about. Then I will share a couple of very powerful numbers that illustrate why some stocks with a PE ratio of 30 or 40 might be incredible opportunities while other stocks with a PE multiple of 10 might still be overpriced.
In a way the PE ratio is a Back-of-the-Envelope Valuation approach as you take the current stock price of a publicly traded company and divide it by the annual earnings per share of that business – usually you’d look at the trailing twelve months of earnings. So for example, if a company is currently trading at $500 a share and its earnings over the last 12 months were $40 per share, the PE ratio for the stock would be 12.5 ($500 divided by $40).
Now I think two things are worth highlighting. First, as a general rule of thumb, with all else being equal, the lower the PE-ratio, the cheaper a company is. That’s a fact. Under the just mentioned assumptions, this statement is true. And secondly, one can say as the PE multiple of a company goes up over time, it shows that investors’ sentiment is turning more favorable and a declining PE-ratio is an indication that the sentiment is turning bearish and investors are becoming more skeptical of the company’s outlook.
It almost seems as if the PE ratio is one of, if not THE most useful way to find undervalued stocks. Almost every investing book on the discipline of value investing seems to discuss the PE ratio in some of its chapters. And especially new investors, immediately feel competent when they are able to use the PE-ratio as a valuation approach to rely on when determining whether a stock is cheap or expensive. But I’d argue that investors’ attitude towards the PE-multiple almost seems to follow the Dunning Kruger curve. At first, understanding the PE ratio gives you this large boost of confidence, but the more experienced you become, the more you understand why a single number (the pe ratio) doesn’t tell you all that much.
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○ What Is the Price-to-Earnings (P/E) Ratio? – Investopedia: https://www.investopedia.com/terms/p/price-earningsratio.asp
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