Stock Valuations 101
Although there may be gurus who hearken to the influence of the Zodiac or lunar cycles, the valuations of most stocks are based on what's known as the price-earnings ratio. In simple terms, that's the price of one share divided by the earnings per share. The latter is the amount of earnings for the company as whole divided by the number of shares outstanding.
The price-earnings ratio depends on several key factors. Perhaps of greatest importance is the company's rate of growth. The rule of thumb is that the faster the rate of growth, the higher the price-earnings ratio, but there's a limit to what would be considered reasonable. A typical range of price-earnings ratios is between 10 and 20 times.
That's true of both individual stocks and the stock market as a whole. Larger, more mature companies will probably grow more slowly while some small companies might well increase their profits more rapidly.
There are caveats. In a perfect world, high growth would be accompanied by consistent progress. That in turn would suggest that there is high confidence that the rate of growth could be maintained, which is why there are instances when stocks carrying very high price-earnings ratios are said to be "priced for perfection". The rub is that the slightest misstep can quickly undermine the valuation, i.e., sharply reduce the price-earnings ratio.
When looking at companies with high price-earnings ratios, it's wise to fully appreciate the risk of something going awry. It happens more often than not and can be quite costly. Just because a company has grown quickly in the past is no reason for the current price-earnings ratio to be stretched. Indeed, the most that should be said for a good historical record is that it may lend a greater measure of confidence (and introduce an element of reduced risk) to where things stand today. The rate of past growth is largely irrelevant.
It's important to differentiate growth from periodic recovery, such as that typical of cyclical companies. The latter usually display boom and bust characteristics. For these companies, a few years of increases are usually followed by a few years of sagging results. As a result, the price-earnings ratio will be high during the years of weak results as investors anticipate the rebound that will probably follow. And vice-versa. Interest rates play an important role, too. When rates are low, price-earnings ratios tend to be high.
Over the past few years, prevailing rates have been at or near historic lows, so typical price-earnings ratios have been above average, largely in reflection of the interest rate environment. But what we're seeing today is nothing like the bloated valuations of the dot.com era, when multiples soared beyond 30 times.
One useful tool for getting a handle on valuations is the PEG ratio. That's the current price-earnings ratio divided by the prospective rate of growth. So, for example, if the p-e is 20 and the projected rate of growth is 10%, the PEG ratio would be 2.0. That's a bit generous, though not unusual. Investors would be better advised to seek out issues where the PEG is lower.
A good understanding of stock valuations is essential to uncovering worthy candidates for one's portfolio. Ignore them at your own risk.
N. Russell Wayne, CFP®
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