For A Quick Ratio Formula Does Current Assets Include Inventory How to Make Money From the Stock Market

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How to Make Money From the Stock Market

One of the most commonly used metrics is the price-to-earnings ratio, or P/E. You can find the P/E on most financial websites that cover individual companies. P/E refers to the price per share divided by earnings per share (also known as net income).

Any company with a P/E below 10 is worth a look. But P/E is not the ultimate determinant of a company’s value. First of all, you should be sure what P/E means. Generally, value refers to the current price and earnings refers to the company’s earnings over the past 12 months. Sometimes this is called a “trailing” P/E.

The problem with trailing P/E is that it is backward looking. It’s also worth looking at the company’s future (or forward) P/E, or its value, compared to projected earnings over the next 12 months. If earnings (the denominator) are increasing, the P/E ratio will go down relative to its trailing P/E.

This is what you want to see.

Another way to look at a company’s future prospects is by looking at its PEG or price-to-earnings-to-growth ratio. Looking at 1.1 or 1.2 won’t take me away from the company, though anything below 1 is excellent.

How does PEG work? Suppose a company has a P/E of 12. And that company has projected annualized earnings of 12% per year over the next five years. Then it will have a 12:12 PEG ratio or a ratio of 1. If its projected growth rate is 15% per year instead of 12%, its PEG ratio will be less than 1. Companies would die for a ratio like this…and here’s why. AP/E of 12 is fine. Remember, I just said I like a P/E of less than 10. The average ratio for the S&P 500 is about 18. So you could argue that I’m depressed. Yes, that’s right. I think the S&P 500 is overvalued – and that’s relative to its historical P/E average. I believe the overall P/E average of the S&P 500 is declining, and I want my companies to have better P/Es not just by today’s standards, but tomorrow’s as well. So we’re back to a P/E of exactly 12, and now you know why. On the other hand, double-digit growth is better than okay.

Compared to the previous five years, it seems that it will be very difficult to achieve double digit growth in the next five years. If investors love double-digit growth and are willing to pay a premium for it now, just wait. That premium is going to be huge.

I consider a company valued at a P/E of 12 (above my cutoff point of 10) to be slightly overvalued – or, another way of saying it, it’s going for a slight premium over fair value. But if it sports a PEG of 12:15 (an impressive minus-1), a small premium is justified and the company goes from overvalued to fair value.

But PEG’s strength is also its weakness. It’s great that it allows you to see into the company’s future, but it does so at the cost of being a little speculative. Remember, the “G” portion of PEG projects increases over a five-year period. The PEG ratio is as good as this projection. If a company underperforms the “G” portion of the PEG ratio, you’ve probably hitched your wagon to the wrong star. The forward P/E is less speculative, as it only projects 12 months of earnings.

And it’s not just the “G” in PEG that muddies the waters. “E” for earnings is a very dirty category by itself. This includes all kinds of nonsense, such as tax write-offs, depreciation, one-time charges, and sales. At the end of the day, it bears little resemblance to a company’s actual operating income.

For these reasons, I like EBITDA (earnings before interest, taxes, depreciation, and amortization) very well – and I believe EV (enterprise value) and EBITDA are a much better ratio than P/E.

EV is a company’s market capitalization plus its cash minus debt. It’s called “enterprise value” because that’s what you’ll pay for the company if it’s for sale.

In addition to P/E, PEG, and EV/EBITDA, there’s one more ratio you should look at: price-to-book (P/B). “Book” refers to net assets or assets minus liabilities. An AP/B less than 1 means that you are making a good buy on the company.

Learn about it. At a P/B of 1, the price per share you pay is equal to the net asset value per share. This means that everything you are getting with the company is free. Trading – and the profits it generates – is free. Future growth of the company? Free too. An AP/B of 1 or less is a phenomenal ratio. But anything less than 2 is still considered good. It works for me. I look at EV/EBITDA first. Then I look at trailing and future P/Es. And then I take PEG and P/B almost at the same time. The more ratios you throw at a company’s value, the better you get a sense of how much — if anything — it’s discounting. Of course, it stands to reason that the riskier you think the company is, the higher the discount should be.

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