Saturday, November 1, 2008

why EPS, PE in stock valuation ?


There are 2 main factors why a stock price goes up and down:
1) fundamental strength of that business ( Strong or Weak )
2) general public view points ( Positive or Negative )
So there are 4 combinations:
Weak Company Negative Views : Price Drops Continously
Weak Company Positive Views : Price Up and Fluctuate
Strong Company Negative Views : Price Drops to substanable level
Strong Company Positive Views : Price Up and Substain
You BUY Strong Company 
during its Negative Views time (3)

and 

You SELL during Positive Views ( 2 & 4 )

EPS or Earning Per Share shows you how much the business earn during a particular period.  Over the years, the EPS growth rate shows you how 'STRONG' the business is.  A consistently grown EPS shows that the business is able to conduct good business despite good or bad times.

PE or Price Earning ratio basically describes how many times a stock price is traded comparing to its earning.  For example, a business may be earning $1 now but its stock price is traded at $10, PE = 10x.

One of the usefulness of this PE is to show confidence level.  For example if I compare 2 businesses of the same nature, one is traded at 10x while another is only 5x.  That shows that general public is more confidence with one business than the other.

I can also examine all the PE numbers for all plantation stocks ( same industry ) and come up with an average or normalize PE, says 8x.  Then compare to the PE of the particular stock I am planning to buy, says 10x.  Then I know many others are also interested in this stock compare to other stocks within the same industry.

If I keep a historical record of PEs, I can also understand the stock price trend better.

So that is why I use EPS and PE, this combination tells me both the company strength and what the market thinks about this business.

4 comments:

Anonymous said...

in addition, I would also look at dividend yield, the willingness of the company to share its profit with its shareholders.

this would indicate good earning, strong cashflow and more "considerate" top management.

companies I know that pay higher dividends, yet affordable are Dialog, Maybulk (not so sure now as the Baltic Dry Index has dropped, Bursa (quite low to RM5++ compared to >RM10)but bank stocks tend to be a bit more expensive.

LWT

Michael Tsen said...

thanks, good point.

There are many aspects in stock investment, one can use stocks in many ways. The way I have been promoting is capital appreciation.

This has to do with style too. For example, if I buy a company, I personally won't care how much dividend it pays me. All I want the business to do is to do good in what its doing and continue growing above market rate.

A good company will use its earning to grow bigger better next year, only when a company has "surplus" after minus this 'next year growth' budget, then only it should share out its profit in dividen. So when a company is paying out dividen, it tells me that this company has reached its maximum growth and always have surplus money that they don't know what else to do with it.

There are a lot of traps with dividen too, quite a lot of local companies use debt to payout dividen, which is a very bad practice.

Dividen investors are investors who want constant payout as compare to FD. Such investors also normally do not need to know about the biz. so the company who love to attract this type of investors are those companies who don't want too many ppl to know about their biz - as long as they pay good dividen, they think these investors should continue keep investing ...

in short, dividen analysis is actually more complicated and that is the area where a lot of traps may be implant by the accountants ...

we have to be careful when considering dividen in our stock valuation.

Anonymous said...

point taken, Michael.

So looking at the annual accounts is also important. Net Tangible Asset per share, cash flow statement as well as gearing ratio will indicate the cashflow and asset backing of the shares.

With the demise of Section 110 refund in 2013 or earlier, dividend has lost some of its appeal.

LWT

Michael Tsen said...

yeap, the more you know the better it is, but a newbie can start with EPS and PE ... that would be the minimum to start with .... my suggestion of this post that is.