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MARKET CRISIS
Is that stock going cheap?
Toni Case - October 30, 2008
The share prices of some of Australia's best-loved stocks have been slammed over the past few months as the global financial storm has hit our shores. Our big banks, miners and industrials have been hit hard. Few companies have been spared.
Many stocks are today trading at levels not seen since 2006 or earlier - wiping out paper gains for loyal buy-and-hold investors who held on. In the US, they're calling them the lost generation of investors – some of whom haven't made a capital gain on many stocks for over a decade.
The good news is that if stocks are going cheap, then picking them up at half price or lower can catapult returns when prices eventually recover.
So how do you know when a stock is going cheap?
The best toolkit to use in these times is that of the bargain hunter, the contrarian or value investor. As other investors head for the exit, bargain hunters start measuring up stocks using a couple of key ratios. Stocks that fit their criteria of a bargain are picked up on the cheap.
A favourite tool of the contrarian is the price/earnings ratio (P/E), which is calculated by dividing the current share price in cents by the company’s earnings per share, or EPS. Thankfully, the historic P/E on stocks is readily available, so you don't have to manually do this calculation yourself.
The P/E ratio is rather useless on its own, but is a handy comparison tool. You can use it to compare one company against its peers, to the overall market, or sector, as well as to track historic performance.
Let's say that one company (Company A) has a P/E of 12 and another company in the same industry (Company B) sports a P/E of 20. For every $1 of current earnings, the investor is effectively paying $12 a share for Company A and $20 a share for Company B.
It's clear that Company A is cheaper than Company B because for every $1 of earnings, you're paying $12 a share instead of $20.
Contrarian investors use this as a guide for finding stocks that are going cheap. They particularly like stocks that are trading on a low P/E relative to their peers and the overall market.
But does that mean that Company A is a better buy than Company B?
As we all know, earnings are the basic ingredients of share price growth, and the best stocks to buy are those exhibiting a trend of increasing earnings (we like to see earnings growth for five years or longer). Remember, earnings refer to “net profits” and not revenue.
When investors spot a company with a trend of increasing earnings, they get excited and buy shares. As more shares are purchased, the share price is bid up, and so is the P/E ratio (since the current share price is the numerator in the ratio). The more popular the stock, the higher its P/E.
So Company B could in fact be a better buy than Company A if its earnings are growing at a faster pace.
There are times however when markets get out of wack. External shocks such as the recent financial crisis send share prices into a spin, and stocks that were once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.
It's times like these that contrarian or value investors come to the fore. With their toolkit in hand, bargain hunters set to work.
A bargain means that you are getting something that should cost $10, for $5. You buy a leather couch on special for $2,000 that a week prior was holding a price tag of $4,000. This is what most of us call a true bargain without thinking too much about it.
But just because the coach was priced at $4,000 the week prior, doesn’t necessarily mean that it's a bargain at $2,000. (It could be old stock, its design could be going out of fashion).
Likewise, just because your favourite stock was trading at a P/E of 10 many months ago, doesn't necessarily mean that it's a steal at 6 today. Basically you have to consider whether the fundamentals have changed.
For example, as consumers tighten their purse strings, will the company struggle to sell its goods and services? If the company has a lot of debt on its books, will it battle to get funding? If it's an importing company, will the fall in the AUD/USD impact its sales?
Sometimes a fall in the P/E can be justified, sometimes not. And getting this right is the true test of whether a contrarian investor spots a bargain or not.
Next week we'll continue our search for finding true bargains at today's prices.
Toni Case is the managing editor of CompareShares and FatCat.
More articles from this edition of CompareShares:
Expert picks: Gerry Harvey reveals his personal investment portfolio, stock holdings and equities outlook for CompareShares readers
Investing: Is that stock going cheap?
Stocks: How to use forecasted earnings to value a stock – focus on Computershare
Property: Boost to First Home Owners Grant a big mistake
Expert Panel: Why short sellers are turning to trading options
Credit Crisis: Govt's ADI proposal could cost billions
Economics: 'Shallow' recession tipped for Australia
Companies: Westpac posts rise in earnings
US: US Fed cuts key interest rate to 1%
Companies: Low nickel price forces Minara's hand
Companies: AGL to sell PNG gas, oil assets
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