07-12-2015, 01:42 PM
The rabbit hole of valuation analysis never ends, but the basic measure of a stock's valuation is P/E. P/E itself can be misleading because the "E" is not a simple statement the company's cash flows, but contains non-cash, intangible expenses, and expenses incurred in the past or future (such as depreciation, amortization, and money set aside for potential settlement of lawsuits). Cash flows are also stated quarterly, but are not necessarily a good alternative to Earnings because all the accounting considerations mentioned above do matter.
A simple way of comparing the P/E ratio to the growth is the PEG, or (P/E)/5 year growth. The PEG ratio is defined differently by different people depending on whether they use trailing or forward P/E and earnings growth figures. The rule of thumb is that below 1 is cheap (EPS growth is higher than the P/E), between 1 and 2 is fair, and above 2 is getting expensive.
Then again, future growth estimates are just that. You could make a solid case that since stocks trade on expectations, finding value in the market means buying companies whose future growth estimates are mistakenly too low, and avoiding those whose estimates are too high. For example, QCOM used to have double digit future EPS growth estimates, and CVX single digits. Now QCOM shows a single digit consensus, and CVX is negative. Both stocks have fallen as the expectations around them have re-rated downward.
This is not to say that you should try to be smarter than the analysts, but simply that valuation figures and growth estimates should not be taken at face value.
A high P/E doesn't necessarily mean a stock is overpriced, and a low P/E doesn't necessarily mean a stock is cheap. MU has had double digit past and future EPS growth figures for a while now, and the P/E is well below 10. Yet it has been a terrible investment over the past year. SBUX once showed a trailing P/E in the hundreds (due to a legal settlement), and a forward P/E of around 30. SBUX has performed like a champ, and the forward P/E is still 30 a year later as the earnings have kept up. And there are plenty of companies whose valuations I just can't make sense of.
I recommend reading articles on Investopedia.com to get familiar with the basic accounting and valuation terms, and buy companies that you know to be high quality when the valuation looks reasonable.
A simple way of comparing the P/E ratio to the growth is the PEG, or (P/E)/5 year growth. The PEG ratio is defined differently by different people depending on whether they use trailing or forward P/E and earnings growth figures. The rule of thumb is that below 1 is cheap (EPS growth is higher than the P/E), between 1 and 2 is fair, and above 2 is getting expensive.
Then again, future growth estimates are just that. You could make a solid case that since stocks trade on expectations, finding value in the market means buying companies whose future growth estimates are mistakenly too low, and avoiding those whose estimates are too high. For example, QCOM used to have double digit future EPS growth estimates, and CVX single digits. Now QCOM shows a single digit consensus, and CVX is negative. Both stocks have fallen as the expectations around them have re-rated downward.
This is not to say that you should try to be smarter than the analysts, but simply that valuation figures and growth estimates should not be taken at face value.
A high P/E doesn't necessarily mean a stock is overpriced, and a low P/E doesn't necessarily mean a stock is cheap. MU has had double digit past and future EPS growth figures for a while now, and the P/E is well below 10. Yet it has been a terrible investment over the past year. SBUX once showed a trailing P/E in the hundreds (due to a legal settlement), and a forward P/E of around 30. SBUX has performed like a champ, and the forward P/E is still 30 a year later as the earnings have kept up. And there are plenty of companies whose valuations I just can't make sense of.
I recommend reading articles on Investopedia.com to get familiar with the basic accounting and valuation terms, and buy companies that you know to be high quality when the valuation looks reasonable.