Implementing P/E ratios is certainly a lousy method to evaluate stock price. Yet, almost everyone actually it. The demand from customers for P/E ratios is so invasive that even most of us incorporate them in our database. But our P/E's are unique from what you will come across in your newspaper.
One good reason for the main difference in P/E's is that we use 12-month expected profit, not really revenue that is based on 12-month trailing performance. Everyone knows that the stock market is a forward looking beast. People gamble on future, not the past. So why make a barely useful number less informative than it could be? One other significant difference is that VectorVest a P/E ratio for each and every stock. For a variety of reasons, including low, zero or negative earnings, you will not find P/E data for about 20% of the stocks listed in media.
But the main factor is that P/E ratios are rarely helpful is that the review of P/E's is totally subjective. There is no independent standard for knowing whether a P/E ratio is too high or too low. Anyone may present you any number of reasons why they think a stock's P/E is too high or too low, and who is to dispute with them?
Years ago, we learned that one could tell whether a stock was over or undervalued by dividing its P/E ratio by its earnings growth rate. The idea was that high P/E ratios may well be justified by high profit improvement rates. So a stock was deemed to be overvalued when the (P/E)/Growth ratio was more than 1.00. This (P/E)/Growth ratio analyze were popularized by Mr. Peter Lynch, the outstanding manager of the Fidelity Magellan Mutual Fund, and it became known as the PEG ratio. The idea of comparing a stock's P/E to its earnings growth rate made sense to me, so I was off to plotting earnings data on semi-log paper and calculating growth rates like you wouldn't believe. Still, quite a few things are bothering.
The one thing that bothered me the most was that I couldn't find a mathematical derivation for the (P/E)/Growth Ratio test, and I looked everywhere I could. This was before Google, of course. My search of PEG Ratio on Google got 408,000 results in 0.29 seconds. Wikipedia says the PEG Ratio, "is primarily a tip of thumb and has no accepted underlying mathematical basis." This statement is not true. Actually, G/PE to PEG is preferred because all of the other key indicators in VectorVest are favorable when they are above 1.00.
As of at present, It is never observed an independent derivation of the PEG or G/PE ratio. Years ago, we used to show this derivation in our Two-Day seminars and the most interesting thing about it is that it shows that the appropriate test ratio for valuation is 1.00 when, and only when, the AAA Corporate Bond Rate equals 10%. Test ratios below 1.00 are acceptable when the bond rate is less than 10%. This phenomenon is explained in our Stock Analysis Reports.
Consider, for example, the instance of F5 Networks, FFIV. It closed Wednesday at $96.36 per share. VectorVest had it valued at $68.71 per share with an RV of 1.43, GRT of 28 %/Yr., P/E of 34.29 and G/PE of 0.82. Is it undervalued or overvalued? If you compared the Price of $96.36 to Value of $68.71, you'd say that it's definitely overvalued. If you're a P/E type of person, you'd have to admit that a P/E of 34.29 is pretty high, so the stock is probably overvalued. If you're a PEG lover, you'd say a PEG of 34.29/28 = 1.22 is greater than one, so the stock is overvalued. You might think a G/PE person, like me, would say the stock is overvalued because 28/34.29 = 0.82 is below 1.00. However, I know enough to consult the VectorVest Stock Analysis Report. Oh my goodness, it says FFIV may be considered to be undervalued because 0.82 is well above the operative G/PE test ratio of 0.13%.
Everything, except the Stock Analysis Report, says that this stock is overvalued. What's going on? Well, last week we said that stock value goes up when interest rates go down. Interest rates currently are at historic lows and the Stock Analysis Report is taking that into account. It's telling the truth. Stocks are cheap. Take a look at RV. At 1.43, it's saying that this stock is likely to outperform a comparable investment in AAA Corporate Bonds by 43% over the next three years.
Think about it. What kind of return will you get on a bond paying 3.6%? In three years you'll make a total return of 11.93%. Don't you think a stock growing at 28 %/Yr. and an RS of 1.44 can appreciate more than 11.93% in three years? Sure, I know FFIV is currently overvalued, but with its high growth rate and fine financial performance, RV says that it's a better investment than buying 3.6% bonds. Anybody who uses P/E or PEG ratios to value stocks without taking interest rates into account is playing a Fool's Game.
BOTTOM FISHING WITH THE BEST
If you're looking to make money virtually every time the market rallies from a dip, you've got to watch this week's "Strategy of the Week" presentation. Visit the VectorVest University and Mr. James Penna will show you how to do it by "Bottom Fishing with the Best."
Author writes regularly about finance and stock related topics. For more information about stock charting software, stock analysis, stock market software visit - http://stockchartingsoftware.wordpress.com
One good reason for the main difference in P/E's is that we use 12-month expected profit, not really revenue that is based on 12-month trailing performance. Everyone knows that the stock market is a forward looking beast. People gamble on future, not the past. So why make a barely useful number less informative than it could be? One other significant difference is that VectorVest a P/E ratio for each and every stock. For a variety of reasons, including low, zero or negative earnings, you will not find P/E data for about 20% of the stocks listed in media.
But the main factor is that P/E ratios are rarely helpful is that the review of P/E's is totally subjective. There is no independent standard for knowing whether a P/E ratio is too high or too low. Anyone may present you any number of reasons why they think a stock's P/E is too high or too low, and who is to dispute with them?
Years ago, we learned that one could tell whether a stock was over or undervalued by dividing its P/E ratio by its earnings growth rate. The idea was that high P/E ratios may well be justified by high profit improvement rates. So a stock was deemed to be overvalued when the (P/E)/Growth ratio was more than 1.00. This (P/E)/Growth ratio analyze were popularized by Mr. Peter Lynch, the outstanding manager of the Fidelity Magellan Mutual Fund, and it became known as the PEG ratio. The idea of comparing a stock's P/E to its earnings growth rate made sense to me, so I was off to plotting earnings data on semi-log paper and calculating growth rates like you wouldn't believe. Still, quite a few things are bothering.
The one thing that bothered me the most was that I couldn't find a mathematical derivation for the (P/E)/Growth Ratio test, and I looked everywhere I could. This was before Google, of course. My search of PEG Ratio on Google got 408,000 results in 0.29 seconds. Wikipedia says the PEG Ratio, "is primarily a tip of thumb and has no accepted underlying mathematical basis." This statement is not true. Actually, G/PE to PEG is preferred because all of the other key indicators in VectorVest are favorable when they are above 1.00.
As of at present, It is never observed an independent derivation of the PEG or G/PE ratio. Years ago, we used to show this derivation in our Two-Day seminars and the most interesting thing about it is that it shows that the appropriate test ratio for valuation is 1.00 when, and only when, the AAA Corporate Bond Rate equals 10%. Test ratios below 1.00 are acceptable when the bond rate is less than 10%. This phenomenon is explained in our Stock Analysis Reports.
Consider, for example, the instance of F5 Networks, FFIV. It closed Wednesday at $96.36 per share. VectorVest had it valued at $68.71 per share with an RV of 1.43, GRT of 28 %/Yr., P/E of 34.29 and G/PE of 0.82. Is it undervalued or overvalued? If you compared the Price of $96.36 to Value of $68.71, you'd say that it's definitely overvalued. If you're a P/E type of person, you'd have to admit that a P/E of 34.29 is pretty high, so the stock is probably overvalued. If you're a PEG lover, you'd say a PEG of 34.29/28 = 1.22 is greater than one, so the stock is overvalued. You might think a G/PE person, like me, would say the stock is overvalued because 28/34.29 = 0.82 is below 1.00. However, I know enough to consult the VectorVest Stock Analysis Report. Oh my goodness, it says FFIV may be considered to be undervalued because 0.82 is well above the operative G/PE test ratio of 0.13%.
Everything, except the Stock Analysis Report, says that this stock is overvalued. What's going on? Well, last week we said that stock value goes up when interest rates go down. Interest rates currently are at historic lows and the Stock Analysis Report is taking that into account. It's telling the truth. Stocks are cheap. Take a look at RV. At 1.43, it's saying that this stock is likely to outperform a comparable investment in AAA Corporate Bonds by 43% over the next three years.
Think about it. What kind of return will you get on a bond paying 3.6%? In three years you'll make a total return of 11.93%. Don't you think a stock growing at 28 %/Yr. and an RS of 1.44 can appreciate more than 11.93% in three years? Sure, I know FFIV is currently overvalued, but with its high growth rate and fine financial performance, RV says that it's a better investment than buying 3.6% bonds. Anybody who uses P/E or PEG ratios to value stocks without taking interest rates into account is playing a Fool's Game.
BOTTOM FISHING WITH THE BEST
If you're looking to make money virtually every time the market rallies from a dip, you've got to watch this week's "Strategy of the Week" presentation. Visit the VectorVest University and Mr. James Penna will show you how to do it by "Bottom Fishing with the Best."
Author writes regularly about finance and stock related topics. For more information about stock charting software, stock analysis, stock market software visit - http://stockchartingsoftware.wordpress.com