In investing there are two schools of investing. There are the momentum investors, also known as the “Castle in the Clouds” investors. These individuals look for a stock that is going up in price rapidly and try to buy in early and sell before the stock tops and starts back down. There are also the value investors, also known as the “firm foundation investors.” These individuals assign a value to a company and try to buy stocks whose prices is well below its value and then sell when the stock goes above its value. Both groups of investors make money.
Even if one is not a value investor, it is useful to determine if the current price for a stock is high or low. Even if it is a great company, if you pay way too much for a company it may be years before you make a decent profit. For example, one of my favorite stocks right now is BJ’s Restaurants (BJRI). Back in 2011 it went from $30 per share to about $60 per share in short order. I think it has a lot of potential to do very well in the future, but at those prices it would take a while for the earnings to justify the price. I therefore sold my shares and bought back in at a lower price. I still didn’t get the bottom (I bought in at about $39), but I still missed a lot of the fall.
Perhaps the best way to value a stock is to look at the price earnings ratio, or PE. This is the price divided by the earnings pr share. Looking at BJRI, the PE is currently about 28. This is a little pricey relative to the market, but is not super rich for a company who is seeing rapid earnings growth. Back when the stock was at $60, it commanded a PE of about 57. Very few stocks can justify that kind of PE for long. Eventually the PE will drop back to a more reasonable level, either because the earnings increase or the stock price decreases.
The PE for the market overall tends to be around 15. This includes the young, up-and-comer stocks and the old household names. The former tend to command higher PEs, because earnings are growing rapidly, while the latter tend to command lower PEs, because their price tends to depend on the dividends they pay. Different sectors of the economy also tend to have different PE ratios. For example, technology companies tend to have high PEs, while utilities tend to have low PEs. Once again, the reason is the rate of earnings growth.
When determining if a stock is overpriced, the first thing is to look at its PE relative to other stocks in its industry, or even the industry average. For example, the PE of Home Depot is currently 24, while that of Lowes is currently at 23, so both of these appear to be equally priced. Realize though that not all stocks are created equally. If a stock is the leader in its industry and growing rapidly it may command a higher PE than an also ran.
The second thing you can do is look at the historical PE. There are not many companies that offer historic PE for a stock for free. Value Line Investment Survey is one paid source. Usually a stock will trade within a range of PE, so if it is at or above the top of its range, it may be overpriced and vice versa.
Any value investors out there? What are the hot value stocks right now? Any momentum investors?
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.