All Successful Investors Know This One Ratio

David Goodboy's picture

Friday, October 28, 2016 - 9:30am

by David Goodboy

All successful stock market investors have one thing in common. Sure, they may have very different ideas and styles, but this one thing remains true across the board. No matter who you ask, from Warren Buffett to your local investment advisor, they will all agree on this single point.   

The point is there is a difference between price and value in the stock market. While the ordinary investor chases price, the winning long-term stock investor understands the importance of value. Understanding value enables you to purchase stocks that are underpriced in the market. These diamonds in the rough are often stocks that will create wealth over the long term.

One way to think about the difference between value and price is that value is real worth, while the price is nothing more than how much market participants are willing to pay. In other words, the price is often reflective of the herd mentality. And these numbers are typically far apart.  

Investors are often willing to pay far more than stock is worth due to hype and upside price momentum. At the same time, stock prices can also be lower than the actual value of the stock. This is often due to investor disinterest, a company or sector that has fallen out of favor, or even something as simple as the financial media ignoring the shares.  

The key to successful long-term stock market investing is to locate stocks whose price is lower than their value.  

So, what exactly does value mean? Value is the intrinsic worth of something. In the stock market, this value is measured several ways.

The most popular way is called the price-earnings (P/E) ratio.

The P/E ratio is the ratio of a company's stock price to its per-share earnings. 

Don't worry!  It is not as complicated as it sounds and is very easy to determine.  

The simple formula is the current stock price divided by its earnings per share.

In practice, the P/E ratio is commonly derived from the earnings per share (EPS) from the last four quarters of earnings.  When earnings statements are used, the P/E ratio is known as a trailing P/E ratio.

Forecasted EPS is also used to determine the P/E ratio.  When EPS estimates for the future four quarters are used, it is called the leading, or estimated, P/E ratio.  While this method of measuring P/E is not as accurate as the trailing method, it is preferred as it deals with the projected future rather than the past.

If you think about it, it makes sense. The past does not equal the future in the stock market, despite many ideas to the contrary. While the projected EPS may not be what occurs; analysts often have an excellent idea of what to expect for EPS over the next year.  

Another way of using the P/E ratio is called a hybrid.  A hybrid P/E ratio uses both the leading and the trailing P/E ratios. This calculation is carried out exactly as it is described, utilizing the EPS of the past two quarters and forecasts of the next two quarters. 

P/E ratios vary widely between sectors and companies. This means that they are best used to compare stocks from the same industry.  

Relatively low-P/E stocks are considered to have upside room for the price to grow. However, stocks with relatively high P/E ratios show a stock in a growth phase, meaning it may soon top out in price.  

One way to use P/E ratios for stock picking is to observe the difference between the trailing and leading P/E number. If the leading P/E reading is higher than the trailing P/E number, it is a bearish signal, since the company is expected to earn less over the next year. At the same time, the opposite is a bullish signal that the corporation is projected to make more over the next year.  

I ran a screen for the best names that are showing bullish P/E ratios. Here's what I found:

Five Stocks To Watch
1.    General Motors (NYSE: GM)
2.    Delta Airlines (NYSE: DAL)
3.    Endo International (Nasdaq: ENDP)
4.    Gilead Sciences (Nasdaq: GILD)
5.    Mylan (Nasdaq: MYL)

Risks To Consider: Low-P/E stocks are not guaranteed winners. There could be very real bearish reasons behind the low reading. Be sure to look for reasons for the low P/E number before investing. Also, corporations have ways to manipulate their P/E ratios, so be certain to consider this fact if you notice a P/E ratio away from the standard industry range.  

Action To Take: After creating a watch list of stocks with relatively low P/E ratios, look for bullish catalysts or changes occurring within the company to lift the shares.  Seeing a price bounce from the lows on price chart may be a signal that a bullish catalyst is at work.  Remember to invest in value and not the price when it comes to long-term investing.  

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.