Earnings – an investor's surest guidepost
Happy St. Patrick's Day! I hope that like me, you'll be raising a green beer and munching on corned beef and cabbage.
As we've all been told, this holiday commemorates the life of the man who allegedly drove snakes from Ireland, among other deeds. And what more proof do we need of his greatness? After all: there are no snakes on Ireland.
Any philosopher-investor readers might point out that this statement is what's known as a "post-hoc fallacy." Just because 'A' happened and we can observe 'B' later, doesn't mean that A caused B.
It's fun to think of St. Patrick driving snakes into the sea, and ridding the Emerald Isle of their scourge – but it would be kind of silly to think that it really happened.
And yet, investors of every stripe commit this same mistake every time they buy into the hobgoblin of past performance. Buying because prices went up yesterday is literally just as illogical as thinking that St. Patrick drove every single snake from Ireland.
*****I can imagine some of you rolling your eyes in boredom, but at the risk of sounding obtuse, earnings are important.
Without getting a good read on earnings, it's nearly impossible to determine the true value of a stock. As Warren Buffett says, "Price is what you pay, value is what you get."
A stock's price at any given time tells us basically nothing about the underlying company UNLESS we can see that company's earnings at the same time.
Amateur investors typically make the mistake of buying a stock because it's going up in price. The use of prior rising prices as an indicator to buy "now" might be responsible for more lost wealth than any other single investment mistake.
For instance, if a company's share price is rising without a commensurate increase in earnings, it means that the company is actually becoming a less attractive investment. It would be the equivalent of paying more for a car that gets the same mileage, just because the price went up yesterday. We're all familiar with people who made the same mistake with housing prices. Just because they went up yesterday, or last month, or for the past ten years, there are no guarantees that the trend will continue.
If the fundamentals are the same, and the price rises, that means the investment is worse, not better than it was before.
Buying a security today because you think you'll be able to find a bigger fool to sell it to tomorrow is called "speculation" – the opposite of investing. Unless and until you find a bigger fool, then you're him. And being foolish even for a moment is no way to invest.
*****To commemorate St. Patrick properly, I'm going to give you a small gift which will greatly improve the luck of your investments.
Hopefully anyone can calculate price to earnings, or PE. You just divide a company's share price by its earnings per share. Even this simple math is usually unnecessary as any stock ticker website like yahoo finance already does it for you.
But PEG is a little different. It's on most stock research portals too, but it's not something you hear a lot about. And on yahoo finance, for example, they only calculate it out for the next 5 years. As small cap investors, that's a little bit long of a holding period.
PEG calculates the PE ratio of a stock in comparison to the growth rate. This calculation allows an investor to determine the valuation of the company relative to its growth rate. Since investors are buying a share in the future success of a business, using PEG to value a stock makes sense.
Once you've calculated PE, deriving the PEG ratio is simple, and can be calculated on a historical basis using the previous year's numbers or those for a trailing 12-month period. Alternatively, you can use forward looking metrics based on guidance or analyst estimates – both of which are available on yahoo.
Using an average of the growth rate for revenues and earnings, you can then quickly calculate PEG. A company with a PE ratio of 20 and a growth rate of 30 percent would have a PEG of 0.66 (PE of 20 divided by 30 percent growth rate).
When looking at PEG ratios, the lower the better as this signifies growth at a reasonable price.
I define high growth companies as those growing at over 20 percent. I've found that these companies are the ones that offer investors the biggest long-term potential for significant capital gains – the goal of small cap investors. Finding companies with growth rates above 20% is not difficult, and the faster the rate of growth, the better.
But remember, due consideration needs to be given to the valuation of the company. Buying growth stocks at any price is not the way to make consistent profits in small cap stocks – but it is a good way to drive profits from your brokerage account – like snakes out of Ireland.
