What is value and when is a stock or market cheap?
In this week’s overview video, Roger discusses the importance of being able to value a company and the importance of having a basis for thinking about when a company or stock market might be cheap. This structure should be able to help you navigate the markets during various storms and solar periods.
When I spoke to you last week, I suggested the idea that the market is poised for potential disappointment. I don’t know if the market will fall, continue to fall, or rise next week, next week, or next week. But I know that if you focus on quality, the other theme of last week’s video, and value, you’ll be fine.
The second part, value is the more difficult part of investors to follow in a disciplined manner because it requires patience. Sometimes you need to stay on the sidelines when the market is rushing forward. So what is value and when is a stock or market cheap?
Well, there’s no right answer to that. There are several models for determining value. There are over-return models, two-stage models, H-models, some parts models. There are so many different ways. And even the price-to-earnings ratio (P/E). There are so many different ways to value a business.
The important thing is that you have a basis for thinking about when a company or stock market might be cheap. This structure should be able to help you navigate the markets during various storms and solar periods. Without knowing what the market will do next, you can still be sure that you are buying at a great price.
Some of you may not have seen our recent blogs on this topic so I want to talk to you about it for those who would rather listen than read. If I buy and sell stocks at the same P/E ratio, whether it’s three years, four years, or five years, regardless of the period. If I buy these stocks at a P/E ratio of 10 and sell them at a P/E ratio of 10, my earnings will equal the growth rate of earnings per share of that particular company.
So if EPS goes up by 15% and I buy shares at a P/E of 10 and sell them at a P/E of 10 five years later, I will earn IRR. , an internal rate of return of 15 percent. Now why is this important?
Well, first of all, recently, in June, stocks got very cheap, simply because the whole stock price crash was due to a P/E squeeze. Price/earnings have declined, but many companies’ profits have not. And last week, you may remember I talked about the REA Group, a business that, even in the face of fierce competition, manages to raise prices and continue to generate growing revenues and profits. Therefore, it is vital to find those quality businesses that will increase their revenues over the next three, four or five years.
But returning to the issue of value, the P/E ratio is not necessarily a measure of value. They are a measure of the popularity of the stock market. Now, in terms of a very simple scheme that Warren Buffett gave us, be greedy when others are afraid and be afraid when others are greedy. P/E’s represent the popularity of a stock or the popularity of the stock market. So if the P/E ratio is down by 30, 40, or 50 percent, you can be sure that the stock has become unpopular. And maybe it’s time to sharpen your pencil.
Taking it one step further, what if, within the next five years after we bought the stock, when it was unpopular, it became popular again? And they will. Well, your earnings will be much better than the growth rate of the company’s earnings, because you will also profit from the revaluation of the shares. And finally, can we safely buy if the P/E ratio falls by 50%, knowing that it could fall even more?
Well, let me give you one simple example. If you buy a company whose earnings per share will grow by 15% per year over the next five years, assuming the P/E does not change, your earnings will be 15%. However, if the P/E drops by a quarter, by 25%, your return over five years will be 9% per year if you continue to own the company whose earnings per share are growing at 15% per year. And finally, where do you start losing money by owning this business at a P/E ratio of, say, 10, which increases profits by 15% per year? Well, you won’t start losing money on this investment until the P/E drops by more than 50 percent. If the P/E drops by 50%, you must hold the stock for five years, and they must increase their earnings by 15% per year so that you can break even. It is now highly likely that even if the P/E ratio declines by 50% within five years, it is likely to rise again.
So that’s the idea for a basis for thinking about P/E ratios or thinking about value, no matter how you want to value companies, but knowing that there’s a big buffer if you’re buying businesses that are growing fast. So stick to quality like I said last week. Look for value, which is what we’re talking about this week. And next week we will add the last element to this trio of investment ideas.
Read my previous blog on the subject:
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