Today I’ll continue with the discussion of price and earnings. Specifically, how to use Price Earnings ratio (PE) and predicted earnings growth rate to predict future prices. This is a continuation of the thread on how a small investor can beat the market returns, started here:
In the previous post in this series, we discussed how the intrinsic value of a stock, which is really what an investor should focus on, is based on expected future earnings and dividends, risk, and the current rate of return of other investment options. The reader should review that post before continuing on:
As stated, the market price of a stock tends to follow the intrinsic value of the stock, at least over long periods of time. This means that if the intrinsic value doubles, the market price will eventually double as well. Because the future intrinsic value is easier to predict than market price, one should find those stocks whose intrinsic value can be predicted to rise at a rapid rate with a reasonable degree of certainty. These are stocks with both a good earnings growth rate and good earning predictability.
Earnings predictability is determined by how stable and solid the market sector and company is. We are looking for stocks that both have predicted earnings growth rates in the range of 10-30% per year and that have had consistent earnings growth in the past. For example, finding a company that has had earnings increase over the last five to ten years and has a business that is still expanding. A company that has seen earnings increase year-after-year obviously has a good management team in place and a concept that is working. As long as neither is expected to change in the foreseeable future, and the company has room to continue to grow, one can expect the earnings growth to continue.
Luckily, these stocks are fairly easy to spot because their price trend tends to follow earnings growth. If earnings have been climbing at a steady pace for the last several years, the price trend should be a nice, steady increase (note the crash in 2008 has caused an interruption in that line for most stocks, so it should be ignored if the stock recovered since then). Stocks that seem to be going straight up should be avoided because these tend to be bubble stocks. Typically the straight up pattern is followed by a straight down pattern, forming a bell curve shape in the price chart.
Another factor to look at when looking for stocks with good growth prospects is the Price Earnings ratio, or PE. This is just the price of the stock divided by the earnings. PE is used sometimes as a measure of price by value investors. For example, they may find stocks with low PEs relative to traditional levels or stocks in a sector with a PE lower than that of its peers. It’s value is compared with it past average value and the stock is considered expensive if PE is higher than average or cheap if it is lower than average. They would buy a stock while the PE is low and then sell if it reached its average or some percentage above its average.
The PE can also be used to predict future prices because a stock will tend to trade within a certain PE range. Therefore, one can do a reasonable job of predicting future price simply by multiplying the expected future earnings by the average PE ratio for the stock. For example, if earnings are expected to increase by 50%, the future intrinsic value, and therefore the price, can be expected to also increase by about 50% if the stock is currently trading at the average PE. If the stock is trading 10% above its average PE it may only increase by 30-40% since some of the future earnings growth is already priced into the stock. Likewise, if it is trading at a below average PE, because the whole market is down or some other reason, the stock price may increase by more that 50%.
Another use of PE is to spot the prime stocks in a business. If one of the stocks in a business segment, restaurants, for example, usually has a PE above that of its peers, it usually means that it is the dominant player in the sector. This is the company that is gaining the most market share and increasing earnings most rapidly, so investors are willing to pay a premium for the stock. As long as the company’s earnings are growing faster than those of the rest of the sector, this premium in PE can be expected to continue. One must be careful, however, because if the management changes or the company just peaks out for some reason and earnings growth slows, its price will fall until the PE is in line with its peers.
In the next post, we will look at the effect of risk on stock price – the “risk premium.”
See the rest of this series: https://smallivy.wordpress.com/category/making-market-beating-returns/
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.