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Tea with Solace: Valuation, PER and Value Trap (Part 1).

Thursday, September 12, 2013

This guest blog by Solace is very helpful to any new investor looking for some pointers and I also feel that it is useful to investors who might be in need of some defragmenting regardless of the number of years they have been investing in the stock market. I know I need this from time to time.



Once, a relative who had 30 years of stock market experience told me that we need to distinguish between a growth company and a growth stock.

Many times, growth companies are not growth stocks because the hype of expected growth had already been reflected in the share price. Growth stocks are stocks whose prices are likely to increase because their values or business fundamentals are unappreciated. We should try to look for growth stocks not growth companies.

A very popular valuation ratio is price to earnings (P/E Ratio). The easiest way to use P/E ratio is to compare it against a benchmark, such as

1) Stock P/E to the average P/E of the entire market,
2) compare against another company in the same industry,
3) compare the same company at a different point in time, company’s Historical P/E.

Some of my friends think that P/E of more than 20 is considered overvalued and P/E of less than 12 is considered undervalued. If only life were so simple.

When looking at P/E, we need to open our eyes and see whether the E makes sense.

The most common way to calculate the PE ratio is to use price divided by a company's reported earnings per share over the last 12 months. This is known as the trailing twelve month (ttm) PE ratio, or the historical PE ratio.

What happens if the company sold its asset or business in the last quarter? It is going to have a very big E, and results in a lower P/E. The stock may suddenly look cheap, but in reality based on operating earnings, the stock isn’t that cheap!
Some investors prefer to look forward and project next year's earnings. This is known as forward P/E. Very often, estimates of future earnings by professional analyst are too optimistic. If enough investors believe in the wrong projection, a bubble will develop. An earnings disappointment will result in a steep price drop!

Some stocks trade at low P/E for a reason. When we are looking at stocks that seem very cheap, we need to look deeper. They could be value traps, in that the stock price would go lower as the company continues to have problems in their operations.

So when we look at stocks that are cheaply price, it is important to look at the quality of earnings and the sustainability of the earning. We have to make sure underlying business is sound before buying into low P/E stocks.

And how are we going to make sure the company fundamentals are sound? Based on my current limited knowledge, I will do a short sharing on some of the points going through my head whenever I try to look at stock that appears cheap.

Continue in Part 2: Here.


yeh said...

i learnt something today.
ak, looking forward for part 2:)

AK71 said...

Hi yeh,

All credit goes to Solace. I enjoyed the blog too. :)

I will publish Part 2 this evening. Need to put in some finishing touches. ;)

Gary said...

Hi AK,

Looking forward to the next part... =))

Solace said...

Hi Yeh,

I am glad that you find it useful. Valuation and identifying good company is a big topic and I still learning new things from time to time.

AK, thanks for posting it up so quickly and sharing w your readers.

AK71 said...

Hi Gary,

Part 2 was published at 7.00pm. ;)

AK71 said...

Hi Solace,

Thank you for a very well written article. :D

Had to get it published quickly. Otherwise, I would have to work at replying to comments on your behalf. I am a lazy guy. Must work fast to prevent getting more work! ;p

Solace said...

Hi AK,

Happy that you enjoyed this post. :)

i know how difficult it is for someone who don't know anything to learn about investment. when i 1st started out, i benefit alot from financial bloggers like you and others who share unreservedly.

I nvr attend any investment course, all i did was to read widely and form my own thoughts & strategy after some time.

So i am glad that i can help new investors who need some pointers to find their own strategy.

AK71 said...

Hi Solace,

I am largely self-taught too. Thought courses too expensive. :(

Recently, I wrote a blog on when to buy, sell or hold which I hope readers will find helpful too: BUY, SELL, HOLD?

If all of us share our knowledge, we can become a powerful force for good. :D

Musicwhiz said...

With regards to valuation, I would think PER alone is too simplistic a method to value firms. You would have to review the characteristics of each company to see which ratio is most applicable to them.

For property companies, most use NAV or RNAV and add a discount.

For asset-heavy companies, you have to value it using P/B or use some measure of asset value to determine if it is cheap or if it offers a margin of safety. Try to assess the fair market value of the assets and be careful of any potential impairments which would impact book value.

For companies which have a negative cash conversion cycle, it may be more prudent to use FCF yield to see if they offer value, or some other cash flow measure. Earnings may not be the most reliable measure.

For heavily geared companies, EV/EBITDA may be appropriate to remove the effects of capital structure, and to compare against competitors.

There is no hard and fast rule with regards to "cheap" or "expensive". Everything is relative and there are no absolutes. What an investor needs to do is to find out what has been incorporated into the share price - to see if expectations have already been priced in. Companies are trading at high valuations for a reason, and that reason could be either because it is much more superior, or it is more efficient, or because of a difference in its capital structure compared to competitors; or it could just be a temporary effect.

The prudent investor would discount all positive news and assume the worst case scenario to attain an appropriate margin of safety.


Solace said...

Hi Music Whiz,

Thanks for dropping a comment :)

Even though you have stopped blogging, I still look forward and enjoy your insight and analysis whenever you post them.

You have mentioned points that are very important too in valuation. This topic is huge, i couldn't have covered everything. Thanks for adding them in and i am sure all readers will find them useful too.

Capricon said...

Hi solace
When you say using price over earnings over 12months, do you mean taking average of the share price for the month and divide by the EPS from last 4 Qtr ?

Is there a tool do this graph plotting ? πŸ˜›πŸ˜›πŸ˜›


Solace said...

Haha, I never see this comment.

AK never alert me lol.

I believe Capricon should have found his answer by now :)

For EPS, depending on what current time quarters we are currently in. For example, if i am in 1Q2016, i use the EPS from annual report FY2015. If we are in 3Q2016, i would use EPS from 3Q2015, 4Q2015, 1Q2016, 2Q2016.

For share price, use the current price that you are looking to invest in to compute.

Graph wise, most accurate is to plot yourself using excel.

I believe Yahoo finance, MSN finance, morning stars can pull out some old data, some shows nice graph too.

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