: How To Determine If Are Cheap

Some ways to price stocks

The (PER) price/earnings ratio is generally considered to be the best measure of whether stocks are “cheap” or “expensive.”

There are several ways to measure price/earnings ratios.

The 1st major distinction in ratios is the difference between trailing ’s and forward ’s.

Trailing PE’s measure the price of a stock against the past 12 months of earnings. This measurement tends to base the value of a stock on the trends it has shown in the past, with the assumption that those trends are likely to continue.

Forward PE’s take the current price of the stock and divide it by the estimated earnings in the coming twelve months. The forward PE bases the value of a stock on the expectations for the growth of the stock, regardless of trends in the past.

In general, forward PE’s can be viewed as how the market values the future, whether based on speculative expectations or projections of proven fundamental trends.

The argument for using forward PE’s, instead of trailing PE’s, for evaluating a stock is that the future is what the market pays for, not the past.

A Key problem with analyzing forward PE’s over a great length of time is the availability of relevant data. Estimates for earnings change frequently, particularly after a Quarterly report or altered guidance.

Should the price to be used for a forward PE be the price on the day that actual trailing earnings are published?

This might be misleading, since changes to estimates generally occur one to two weeks after a quarterly report or guidance, and not all analysts publish their changed estimates on the same day.

Trailing PE’s, on the other hand, use the fully reported actual earnings and the price on the day that the PE is measured.

Another argument for using trailing PE’s instead of forward PE’s is that many earnings estimates are not true reflections of expectations for a company.

Few analysts will forecast an earnings estimate that is higher than guidance given by the company, even when the analyst and the market fully expects the company to beat the guidance numbers, meaning that the forward PE for that stock is artificially high since the denominator in the ratio is artificially low.

While forward PEs are useful for individual stocks, in general, when stocks as a group are evaluated, trailing PE’s are most frequently used.

The reason for this is that, over time, the overall expectations for groups of stocks tends to even out in a group, with excessive expectations for some stocks balanced by overly pessimistic expectations for others.

In addition, the pricing of a stock one year later tends to reflect how well the expectations for the forward PEs of a year earlier were met.

The difference between operating earnings and as-reported GAAP earnings is that 1-time, non-recurring charges are excluded from operating earnings.

The market tends to focus on operating earnings when valuing stocks. Over time, the impact of one-time charges does affect the health and growth of a business, but the short-term focus of many traders tends to overlook any major difference between operating earnings and as-reported GAAP earnings.

The concept of whether a stock is “cheap” or not depends upon the comparison of its current price to its future price.

There are 2 Key variables to consider when considering the possible future value of stocks.

1. Projected earnings: whether the projected increase occurs or not

2. Projected multiple: whether the current multiple upon earnings remains the same or changes

A scenario of falling or flat earnings combined with rising trailing PE’s is hard to project.

I f you make the assumption that the trailing PE will rise towards its 20 yr average of 19.0, and that the projected earnings will occur, then the potential increase in the S&P 500 Index could be greater than it is nnow. The combination of rising earnings and multiples placed upon those earnings may results in high returns.

To answer the question of “are stocks cheap?” requires making a decision about the Key variables.

At some point, if you believe that the price of stocks is based upon the potential for earnings growth, than this combination of rising earnings and declining multiples cannot last. Such a belief implies strong potential growth in the price of stocks in the future, which can also be phrased as “stocks are cheap.”

But, if you do not believe that the projected earnings will in fact occur, then it is likely that the trend of declining multiples on earnings will continue, the combination of which would lead to much lower levels of stock prices. Then, the current level of stock prices is probably overvalued.

This brings the Big Q: Is it reasonable to believe that the projected earnings for stocks in general will continue to rise, as they have steadily since Q-4 of Y 2008?

On this question rests the issue of whether stocks are cheap or not.

Participants often believe that the projected earnings over the next 6 Quarters will turn out to be accurate, at least in the overall trend.

And then this Big Q: Is it likely that the overall market will continue to place no value on rising earnings and maintain indexes at current levels, driving trailing PE’s ratios to all-time lows?

That question is harder to answer.

After all it is true in a raging Bull Market that just because stocks are overpriced does not mean they cannot go higher. And so it seems reasonable to state, “just because stocks are cheap does not mean they cannot go lower.

The name of the stock game is to make money, and it is your money and so your responsibility. Work at it, as it can be rewarding in the extreme.

By Robert V. Green, Investment Strategist

, Editor