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

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.

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From: http://singaporeanstocksinvestor.blogspot.sg/2013/08/how-to-be-one-up-on-wall-street.html

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.