This is an excerpt from the Liberated Stock Trader Book and accompanying Training Course. Chapter 4 – Section 4 – The P/E Ratio
Now that we understand there are different types of stocks or companies out there we can take a look at how to fundamentally evaluate if a business is healthy or not.
Having some knowledge that a company will not be declaring bankruptcy anytime soon is the minimum goal, however the more refined investor will be looking for stocks that are reasonably priced, have low amounts of debt or at least the ability to easily repay that debt, strong sales growth or revenue growth, a decent amount of cash in the bank, and solid earnings.
Also, if you are familiar with the company’s product and how important that product is to the business can give you an additional insight.
Is the company reasonably priced? The P/E Ratio
The Price to Earnings ratio is a simple calculation that may take a little bit of time to understand. But once you have it, it can be very useful. The P/E Ratio is the Share Price divided by the earnings.
Let us imagine I want to by an Ice-cream Stand. The Owner wants to sell that stand to me for $10,000. I have estimated a yearly profit (after tax) of $2,000. This means it would take me 5 years to make my money back on this investment. Therefore the Price I paid divided by the earnings equals 5.
This is what the P/E Ratio or the “Multiple” tells us. In the example above I used the example of buying a whole business and we are considering all of the profits. The P/E Ratio achieves this same goal by using the Individual Share Price / Earnings per Share.
The P/E Ratio can tell you what kind of premium investors are willing to pay to get a piece of this company. P/E Ratios should always be considered in the context of the industry group.
Price Earning Relative Value Example
For example compare the P/E of companies in the same industry, this will tell you which companies are perceived to have the brightest future or the best products or services as the investors are willing to pay more for a share of one company as opposed to another company that are in the same line of business.
Company A – P/E 50 – If 50 is the highest PE in the industry then people believe this company has the best profit growth potential in the future.
Company B – P/E 25 – If 25 was the industry average then this company would be seen as a fairly priced stock for the industry.
Company C – P/E 5 – This company would be seen as an underperformer / or a stock with potential value. If the earnings suddenly jumped for this stock this could potentially be a good bargain.
The PE Ratio needs to be combined with other fundamental measures to get a much better picture of the stock.
The article goes on to discuss how important the P/E Ratio is when you use it to view the P/E of an entire Market using the S&P Composite as a reference, and enabling you to really understand historically if a market is overpriced. Absolutely critical knowledge.
Other Chapters of the Liberated Stock Trader Book are listed below
This chapter sets the stage for the two key areas of stock market technical analysis and the fundamental analysis of companies including macro and micro economics
This chapter looks at what REALLY makes the markets move, what causes boom and bust cycles and how to spot them.
What are stock market cycles and the cycles of business and economies. Important information that you need to appreciate as part of your core analysis.
Next we move into fundamental analysis and the financial fitness of a company. All the major indicators and measures are covered.
Stock screening means using criteria to short list the kind of stock that you want to purchase. A vital part of any stock market training
Once you know the business climate, the state of the economy and you have shortlisted the stocks you want to buy. The next thing to do is the technical analysis. Even if the company looks great on paper, if the stock price is plummeting you do not want to buy it until it has bottomed out. This is called catching a falling knife. This is what chart patterns and technical analysis helps with.
Here we get into the art of drawing on charts to help you visualize the Supply and Demand on the stock, the direction of the trend and estimate how long the trend will last. Vital for you to establish buy and sell signals.
Which indicators should you use, there are literally hundreds of stock chart indicators. Each have a specific use case and application, which should you use?
Volume is a vital indicator along with price. Both of these you need to understand in granular detail, you will learn everything you need to know.
Moving to advanced technical analysis we cover indicators such as parabolic SAR and point & figure charts.
How are the market participants feeling? Positive, Negative or indifferent. Consider that 90% of people fail to beat the average market returns, sentiment indicators can be a great contrary indicator. Lean how to use them to your advantage.
Understanding how you want to invest, how much time you have and your time horizon. These questions all help you to understand what type of investor you want to be, this then enables you to select the right strategy for you. Then we move on to building your stock investing system, a critical element to your plan.