ALL ABOUT EARNING

 

 


INTRODUCTION

Let’s say you noticed sensormatic, the company that invented the clever tag and buzzer for foiling shoplifters, and whose stocks rose from $2 to $42 as the business expanded between 1979 and 1983. Your broker tells you it is small company and the fast grower. Or perhaps you’ve reviewed your portfolio and you have found two stalwarts and three cyclicals. What possible assurance do you have that sensormatic, or any of the stocks you own already, will go up in price? And if you are buying, how much should you pay?

What you are asking here is make a company valuable, and why it will be more valuable tomorrow than it is today. There are many theories, but to me it always comes down to earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investor begins to doubt that will ever happen. But value always win out-or at least in enough cases that it’s worthwhile to believe it.

Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It is a part ownership of a business.

 

THE FAMOUS P/E RATIO

Any serious discussion of earning involves the price/earnings ratio-also known as P/E ratio, the price-earnings multiple, or simply, the multiple. This ratio is numerical shorthand for the relationship between the stock price and earning of the company.



The P/E ratio for each stock is listed in the daily stocks table of most major newspaper as shown here. The P/E ratio is often a useful measure of whether any stock is overpriced, fairly priced, or under-priced relative to a company’s money making potential.

The P/E ratio can be thought of as the numbers of years it will take to company to earn back the amount of your initial investment- assuming, of course, that the company’s earnings stay constant. Let’s say you buy 100 share of XYZ Company for $3,500. Current earnings are $3.5 per share, so your 100 share will earn $350 in one year, and the original investment of $3,500 will be earned back in ten years. However, you don’t have to go through this exercise because the P/E ratio of 10 tells you it’s ten years.

If you buy share in a company selling at two times earning (a P/E of two), you will earn back your initial investment in two years, but in a company selling at 40 times earnings (a P/E ratio 40) it would take 40 years to earn back your initial investment. Cher might be a great grandmother by then. With all the low P/E opportunities around, why then would anybody buy a stock with high P/E? Because they’re looking for Harrison Ford at the lumber yard. Corporate earning does not stay constant any more than human earnings do.

 

MORE ABOUT P/E RATIO

A company with a high P/E must have incredible earning growth to justify the high price that’s been put on the stock. In 1972, McDonald’s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a P/E of 50. There was a no way that McDonald’s could live up to those expectations, and the stock price fell from $75 to $25, sending the P/E back to more realistic 13. There wasn’t anything wrong with McDonald’s. It was simply overpriced at $75 in 1972.

Company P/E ratio do not exist in a vacuum. The stock market as a whole has its own collective P/E ratio, which is a good indicator of whether the market at large is overpriced or under-priced.

 

FUTURE EARNINGS


Future earnings, there is the rub. How do you predict those? The best you can get from earnings ids an educated guess whether a stock is fairly priced. If you do this much, you will never buy a Polaroid or an Avon at a 40 P/E, nor will you overpay for Bristol-Myers, Coca-Cola or McDonald’s.

If you can’t predict future earning, at least you can find out how a company plans to increase its earnings. Then you can heck periodically to see if the plans are working out. There are five basic ways a company can increase earnings: reduce costs, raise prices, expand into new markets, sell more of its product in the old markets, or revitalize, close or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.

 

 

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Congratulation you take one more step towards your financial freedom.

This summary from Book-“One Up On Wall Street”

 

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