How To Use The P/E Ratio And PEG To Tell A Stock's Future

It is common practice for investors to use the price-to-earnings ratio (P/E ratio or price multiple) to determine if a company's stock price is over or undervalued. Companies with a high P/E ratio are typically growth stocks. However, their relatively high multiples do not necessarily mean their stocks are overpriced and not good buys for the long term.

TUTORIAL: Understanding the P/E Ratio

Let's take a closer look at what the P/E ratio tells us:

P/E Ratio

There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. After all, earnings represent profits, and that's what every business strives for. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively it will not have positive earnings, and problems will eventually arise. Learn more about how to use the price-to-earnings ratio to reveal a stocks real market value. Read Profit With The Power Of Price-To-Earnings.)

Besides earnings, there are other factors that affect the value of a stock. For example:

•Brand - The name of a product or company has value. Established brands such as Proctor & Gamble are worth billions.

•Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company.

•Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements.

•Barriers to Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. For example, most anyone can make a soda, but marketing and distributing that beverage on the same level as Coca-Cola is very costly.

All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings (trailing 12 months), it gives a less accurate reflection of these growth potentials.

The relationship between the price/earnings ratio and earnings growth tells a more complete story than the P/E on its own. This is called the PEG ratio and is formulated as:

*The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing, and either a one- to five-year time span. Check with the source providing the PEG ratio to see what kind of number they use.

Looking at the value of PEG of companies is similar to looking at the P/E ratio: A lower PEG means the stock is more undervalued.

Comparative Value

Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E ratio of 50. The second company is in the beer brewing business. It has lower earnings growth at 10% and its P/E ratio is also relatively low at 15. (There are many other common ratios to use when comparing stocks, such as the P/S ratio. Learn more in How To Use Price-To-Sales Ratios To Value Stock.)

Many investors justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

Sponsored - Networking Company:

•P/E ratio (50) divided by the annual earnings growth rate (20) = PEG ratio of 2.5

Beer Company:

•P/E ratio (15) divided by the annual earnings growth rate (10) = PEG ratio of 1.5

The PEG ratio shows us that, when compare to the beer company, the always-popular tech company doesn't have the growth rate to justify its higher P/E, and its stock price appears overvalued.

The Bottom Line

Subjecting the traditional P/E ratio to the impact of future earnings growth produces the more informative PEG ratio. The PEG ratio provides more insight about a stock's current valuation. By providing a forward-looking perspective, the PEG is a valuable evaluative tool for investors attempting to discern a stock's future prospects.

(Every investor wants an edge in predicting a company's future, but a company's earnings guidance statements may not be a reliable source. To learn more, read Can Earnings Guidance Predict The Future ?)

Source: http://www.investopedia.com/
Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

Profiting From Panic Selling

Panic selling occurs when a stock price rapidly declines on high volume. This often happens when some event forces investors to re-evaluate the stock's intrinsic value, or when short-term traders are able to force the stock price down far enough to trigger long-term stop-losses. The entire process creates a tremendous opportunity for bottom-fishers to initiate long positions, especially if the event behind the panic selling was non-material or speculative in nature (such as a SEC investigation or an analyst opinion). Here, we shed light on the panic-selling process and introduce a model that can help you predict the right time to take a long position after panic selling occurs.

The Process
Panic selling happens in several phases. Figure 1 illustrates a typical panic selling scenario that occurred as a result of a SEC investigation. The company in this example is Doral Financial (NYSE:DRL), a corporation whose primary business is mortgage banking, but this chart can be read as a general illustration of what happens in panic selling situations.

Let's break down what happens at each numbered step in the chart:

Step 1 - Something occurs that causes the stock price to rapidly decline on high volume.

Step 2 - Eventually, a high volume day occurs when buyers and sellers fight for control of the trend. The winner then takes the trend on low follow-up volume.

Step 3 - If no significant trend change occurs at point 2 (i.e., a continuation), then there is typically another point of high volume in which a substantial reversal (long or short term) may occur.

Step 4 - This process continues until a long-term trend is established and confirmed with technical or fundamental factors.

Now we'll look at how we can predict when a trend change is going to occur.

The Exhausted Selling Model
The exhausted selling model (ESM) was developed to determine when a price floor has been reached. This is done by using a combination of the following trend, volume and turnaround indicators:

•Trendlines
•Volume
•Moving Averages
•Chart Patterns
Figure 2 illustrates how this model works.

Notice that a variety of indicators are used to confirm that the trend has changed. As a trader, you may choose how many confirmation indicators you wish to use. The fewer confirmation indicators used, the higher the risk and the higher the reward (in the sense that, the longer you wait for confirmation, the less potential gain there will be for you to capture), and vice versa.


The rules to using the ESM are as follows:

1.The stock price must first rapidly decline on high volume.
2.A volume spike will occur, creating a new low, and appear to reverse the trend. Look for candlestick patterns showing a struggle between buyers and sellers here (i.e., cross patterns or engulfings).
3.A higher low wave must occur.
4.A break of the predominant downward trendline must occur.
5.The 40 and/or 50-day moving averages must be broken.
6.The 40 and/or 50-day moving average must then be retested and hold.
Note that you may use other moving averages - ideally, ones that connect highs or lows. Typically, a break of a larger moving average is more indicative of a trend break than smaller moving averages.

As you can see, the ESM combines several techniques to ensure that the trend has changed for the long term.

Example
Now let's take a look at Figure 3, which will show the ESM in practice

Chicago Bridge & Iron (NYSE:CBI) announced that its earnings would be delayed, which sent the stock down 16% in a matter of hours. First, we can see that the low was made on high volume just before 11:26 a.m. Next, the price moves up slightly, but eventually forms a descending triangle, from which we drew a trendline (indicated here by the red line). Next, the price breaks through the trendline and moving averages (indicated by the green dot on the left). It then retraces to the moving averages (shown by the green dot on the right) before moving upwards.

Finally, we can see that CBI turns around and returns to its previous levels after all of the confirmations are present. Note that if you would have entered after just one or two of the indicators, you would have made more profit, but increased the risk of the trade.

The Bottom Line
Panic selling naturally creates great buying opportunities for well-informed traders and investors. Those who know when the selling is over can benefit from the retracements/turnaround that often occur afterwards. The exhausted selling model explained here provides a safe and effective method to determine where the best entry point is, and the ESM's use of multiple indicators can help you avoid costly mistakes.

by Justin Kuepper

Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.
Source: http://www.investopedia.com/articles/trading/06/ESM.asp#ixzz2jOfN27p0

Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

Value Investing Using The Enterprise Multiple

Value investing refers to investing in companies trading significantly below their historic averages and below the market. Cyclical companies, such as energy, materials, and metals and mining are considered to be value stocks during times when the cycle is in the bottom half. However, any company, regardless of industry, can be considered value at different points in the business cycle. Read on to find out how you can take advantage of value investing by using the enterprise multiple.

Valuing a Stock

Value stocks are characterized by low multiples, high payout ratios and strong yields. Common multiples, such as price to earnings (P/E), price to book (P/B), enterprise value (EV), earnings before interest, taxes, depreciation and amortization (EBITDA) or the enterprise multiple, are applied to ascertain the trading value of a stock. P/E looks at today's stock price relative to the earnings. P/B relates today's stock price to the book value of the company. The enterprise multiple takes into account a company's debt and cash levels in addition to its stock price and relates that value to the firm's cash profitability. Each of these multiples has flaws, but the enterprise multiple is the most encompassing and generally considered the most useful in analyzing the current valuation of a stock. High payout ratios indicate the firm is returning cash to the shareholder in the form of dividends, rather than re-investing the profits in the company. Strong yields, particularly free cash flow yield, determine the return to the shareholder after all the cash expenses for operating a business and investment in capital expenditures are spent.

Enterprise Value

Enterprise value is the total value of a company. Whereas multiples that use the stock price look only at the equity side of a stock, enterprise value includes a company's debt, cash and minority interests. It is calculated as market capitalization (stock price times shares outstanding) plus net debt (total debt minus cash and equivalents) plus minority interest. Investors use enterprise value to determine how debt financing, corresponding interest payments and joint ventures impact a company's value. (Read EV Gets Into Gear for more information on comparing companies with different capital structures.)

EBITA

EBITDA is calculated from the income statement. As the name implies, it is calculated as operating profit, adding back depreciation and amortization. Analysts and companies use this as a measure of the true cash operating profit of a company since depreciation and amortization are non-cash items and taxes and interest are not considered part of the operations of the company even though these two items impact earnings. (For further reading, see EBITDA: Challenging The Calculation.)

Measurements

Proper and optimal capital structure is the key to a company's ability to operate profitably and thus should be considered when valuing a stock.

EV is an appropriate way to measure the value of the entire company rather than just the stock price, which looks only at the equity market capitalization of the stock, ignoring the company's cash, minority interests and debt. The enterprise multiple compares the total value of a company relative to its cash profits. It is often more desirable than P/E because EBITDA is considered less manipulable than earnings and than P/B because it is a better measure of cash profitability than book value. However, it is not without its flaws. Consider using more appropriate multiples when valuing highly levered companies where debt servicing, long lived assets or book value drives profitability.

Stocks with an enterprise multiple of less than 7.5x based on the last twelve months (LTM) is generally considered a value. However, using a strict cutoff is generally not appropriate because this is not an exact science. Often investors will consider enterprise multiples below the market, the company's peers and its historical average of a stock as a good entry point. However, cyclical stocks usually have a wide dispersion between the peak (high) and trough (low). This creates the need to take the current multiple in context, including where the industry and company are in their cycle, the fundamentals of the industry, and the catalysts driving the stock relative to its peers. Considering these factors will determine whether the LTM multiple is inexpensive or expensive. (Discover the differences between stocks in different industries, in Cyclical Versus Non-Cyclical Stocks.)

Value Traps

Value traps are stocks with low multiples; this creates the illusion of a value investment, but the fundamentals of the industry or company point toward negative returns. (Check out Value Traps: Bargain Hunters Beware! for further reading.)

Investors tend to assume that a stock's past performance is indicative of future returns and when the multiple comes down, they often jump at the opportunity to buy it at such a "cheap" value. Knowledge of the industry and company fundamentals can help assess the stock's actual value. One easy way to do this is to look at expected (forward) profitability (EBITDA) and determine whether the projections pass the test. Forward multiples should be lower than current LTM multiples; if they are higher, it generally means the profits will be declining and the stock price is not reflecting this decline. Sometimes forward multiples can look extremely inexpensive. Value traps occur when these forward multiples look overly cheap but the reality is the projected EBITDA is too high and the stock price has already fallen, reflecting the market's cautiousness. As such, it's important to know the company's and industry's catalysts.

Conclusion
Investing in stocks requires knowledge of a company's fundamentals, assessing its peers and using a common denominator, such as the enterprise multiple. The enterprise multiple is a proxy for how inexpensive or expensive a stock is trading today based on past and expected cash flows. However using the enterprise multiple is not foolproof and even if a stock is cheap on a multiple basis, market sentiment may be negative.

To learn from the original value investor, read The Intelligent Investor Benjamin Graham.

Source : Read more: http://www.investopedia.com/articles/fundamental-analysis/08/enterprise-multiple.asp?partner=basics021710#ixzz1mtXocg6E

Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

6 Dangerous Moves For First-Time Investors

Thanks to online discount brokerages, anyone with an Internet connection and a bank account can be up and trading stocks within a week. This ease of access is great because it encourages more people to explore investing for themselves, rather than depending on mutual funds or money managers. However, there are some common mistakes that first time investors have to be aware of before they try picking stocks like Buffett or shorting like Soros. (To learn more, see Billionaire Portfolios: What Are They Hiding?)

TUTORIAL: 20 Investments To Know

Jumping In Head First

The basics of investing are quite simple in theory – buy low and sell high. In practice, however, you have to know what is low and what is high in a market where everything hinges on different readings of a variety of ratios and metrics. What is high to the seller is considered low (enough) to the buyer in any transaction, so you can see how different conclusions can be drawn from the same market information. Because of the relative nature of the market, it is important to study up a bit before jumping in. (To learn more, see Stochastics: An Accurate Buy And Sell Indicator.)

At the very least, know the basic metrics such as book value, dividend yield, price-earnings ratio (P/E) and so on, and understand how they are calculated and where their major weaknesses lie. While you are learning, you can see how your conclusions work out by using virtual money in a stock simulator. Most likely, you'll find that the market is much more complex than a few ratios can express, but learning those and testing them on a demo account can help lead you to the next level of study. (Watching metrics like book value and P/E are crucial to value investing. Get acquainted with 5 Must-Have Metrics for Value Investing.)

Playing Penny Stocks

At first glance, penny stocks seem like a great idea. With as little as $100, you can get a lot more shares in a penny stock than a blue chip that might cost $50 a share. And, if the two blue chip shares you bought went up $1 you'd only make $2, whereas if 100 shares of a $1 stock went up a $1 you would double your money. Unfortunately, what penny stocks offer in position size and potential profitability has to measure against the volatility that they face. Penny stocks can shoot up. It happens all the time - but they can also crash in moments, and are exceptionally vulnerable to manipulation and illiquidity. Getting solid information on penny stocks can also be difficult, making them a poor choice for an investor who is still learning. (To learn more, read The Lowdown On Penny Stocks.)

Going All In with One Investment

Investing 100% of your capital in a specific market, whether it is the stock market, commodity futures, forex or even bonds is not a good move. Although you may eventually decide to throw diversification to the wind and put all your available capital into these markets once you are familiar with them, it is better to risk a little bit of capital at a time. This way, the lessons learned along the way are less costly, but still valuable. (Diversification entails calculating correlation, learn more about it by reading Diversification: Protecting Portfolios From Mass Destruction.)

Leveraging Up

Leveraging your money by using a margin is similar to going all in, but much more damaging. Using leverage magnifies both the gains and the losses on a given investment. Some forms of leverage, such as options, have a limited downside or can be controlled by using specific market orders, as in forex. Learning to control the amount of capital at risk comes with practice, and until an investor learns that control, leverage is best taken in small doses (if at all). (Read more with Leverage's "Double-Edged Sword" Need Not Cut Deep.)

Investing Cash Reserves

Studies have shown that cash put into the market in bulk rather than incrementally has a better overall return, but this doesn't mean you should invest to the point of illiquidity. Investing is a long-term business whether you are a buy-and-hold investor or a trader, and staying in business requires having cash on the sidelines for emergencies and opportunities. Sure, cash on the sidelines doesn't earn any returns, but having all your cash in the market is a risk that even professional investors won't take. If you only have enough cash to invest or have an emergency cash reserve, then you're not in a position financially where investing makes sense. (To learn more about liquidity's importance, read Understanding Financial Liquidity.)

Chasing News

Trying to guess what will be the next "Apple," a revolutionary produce or a rumor of earth shaking earnings, investing on news is a terrible move for first time investors. The best case scenario is that you get lucky, and then keep doing it until your luck fails. The worst case scenario is that you get stuck jumping in late (or investing on the wrong rumor) time and time again before you give up on investing. Rather than following rumors, the ideal first investments are in companies you understand and have a personal experience dealing with. This connection makes it easier to stomach the time and research that investing demands. (For more on the psychology of trading, read How The Power Of The Masses Drives The Market.)

The Bottom Line

When you are starting to invest, it is best to start small and take the risks with money you are prepared to lose. As you gain confidence and become more adept at evaluating stocks and reading the market sentiment, you can start making bigger investments. None of these investments are bad in and of themselves, but they do tend to be very unforgiving towards rookie mistakes. Leverage, penny stocks, news trading, etc. can all become part of your investing strategy as you learn, should you choose it. The trick is learning to invest in more stable markets before you jump into the wilder areas.

by Andrew Beattie

Andrew Beattie is a former managing editor and longtime contributor at Investopedia.com. He operates the Wandering Wordsmith blog, and can be reached there.

Source : Read more: http://www.investopedia.com/articles/basics/11/dangerous-moves-first-time-investors.asp#ixzz1irxMKSHH

Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.