In The Capitalization Formula What Does The I Stand For How to Make Money From the Stock Market

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How to Make Money From the Stock Market

One of the most commonly used metrics is the price-to-earnings ratio, or P/E. You can find P/E on most financial websites that cover individual companies. P/E refers to share price over earnings per share (also known as net earnings).

Any company with a P/E below 10 is worth investigating. But P/E is not the bottom line in deciding a company’s price. First, you need to be sure what P/E stands for. Typically, price refers to the current price and revenue refers to the company’s earnings over the last 12 months. This is sometimes called the “trail” P/E.

The problem with the trailing P/E is that it is backward looking. It’s also worth looking at the company’s future (or forward) P/E, or its price compared to its projected earnings over the next 12 months. As earnings (the denominator) increase, the P/E ratio decreases relative to its trailing P/E.

That’s what you like to see.

Another way to get an idea of ​​a company’s future prospects is to look at its PEG, or price-to-earnings-growth ratio. Anything under 1 is great, although seeing 1.1 or 1.2 won’t drive me away from the company.

How does PEG work? Let’s say a company has a P/E of 12. And this company has projected annual earnings of 12% per year for the next five years. Its PEG ratio would then be 12:12, or a ratio of 1. If its projected growth rate is 15% per year instead of 12%, its PEG ratio would be less than 1. Companies would die for that ratio … and here’s why. AP/E from 12 is just okay. Remember, I just said I like a P/E below 10. The average ratio for the S&P 500 is about 18. So you could argue I’m being squeamish. Yes, of course. I think the S&P 500 is way overvalued — and that’s relative to its historical P/E average. I believe the overall P/E average of the S&P 500 is declining and I don’t want my companies to have a good P/E not just by today’s standards, but also by tomorrow’s standards. So we’re back to a 12 P/E, which is okay, and now you know why. On the other hand, double-digit growth is better than okay.

Achieving double-digit growth in the next five years is going to be much more difficult than it has been in the past five years. If investors love double-digit growth and are willing to pay a premium for it now, just wait. This premium becomes much larger.

I think a company with a P/E of 12 (just above my cutoff point of 10) is slightly overvalued – or, in other words, it’s paying a slightly higher price than fair value. But if it also has a PEG of 12:15 (an impressive less than 1), the small premium becomes justified and the company goes from overvalued to fairly priced.

But PEG’s strength is also its weakness. It’s nice that it gives you a peek into the future of the business, but it does so at the cost of becoming a bit speculative. Remember that the G portion of PEG projects growth over five years. The PEG ratio is as good as this projection. If a company can’t meet the G part of the PEG ratio, you’ve probably hitched your wagon to the wrong star. The forward P/E is less speculative because it only projects 12 months of earnings.

And it’s not just the “G” in PEG that interferes with water. Pay “E” is a rather confusing category in itself. It includes all kinds of crap like tax write-offs, depreciation, one-time charges, and sales. Ultimately, it bears no resemblance to the company’s actual operating income.

For these reasons, I like EBITDA (earnings before interest, taxes, depreciation and amortization) much better – and I believe EV (enterprise value) to EBITDA is a much better ratio than P/E.

EV is simply a company’s market capitalization plus cash minus debt. It’s called “enterprise value” because that’s what you’d pay for the business if it were for sale.

In addition to P/E, PEG, and EV/EBITDA, there’s another ratio you should look at: price-to-book (P/B). “Book” refers to net assets or assets less liabilities. An AP/B below 1 also means you’re getting a great buy from the company.

Think about it. If the P/B is 1, the share price you pay is the same as the net asset value per share. This means that everything else you get with the company is free. The business – and the profits from it – IS FREE. Further growth of the company? Free too. An AP/B of 1 or less is a phenomenal ratio. But anything less than 2 is still considered good. This is what works for me. First I look at EV/EBITDA. Then I look at the trailing and future P/Es. And then I take PEG and P/B around the same time. The more you relate to a company’s price, the better you’ll know how much — if at all — it’s discounted. Of course, it makes sense that the riskier you consider the company to be, the bigger the discount should be.

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