Are P/E Ratios Leading You Away from Your Biggest Winners?

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Everyone wants a bargain, but some bargains can cost you. In fact, they can hoover away thousands of dollars in lost profits and years of your time... time spent waiting... and waiting... and waiting some more for these bargain stocks to finally realize their potential. Oh, and did I mention, that’s only IF they realize their potential, which is by no means guaranteed.

Dr. Bart DiLiddo, founder of VectorVest, writes about his own problems with P/E ratios and what he did to solve them.

“My ability to make money in the stock market improved dramatically after I wrote my formulas for assessing stock value and risk back in 1978. I never had much luck picking stocks by using P/E ratios. They were all over the place and there wasn't any way to know if a stock's P/E ratio was fair or not. I learned that some analysts liked to compare the P/E ratio to earnings growth as a metric, but even that wasn't good enough for me. So I continued to compare Price to Value for several years and did well, except there was one stock that bugged me... Walmart (WMT).

I wanted to buy WMT because its price kept going higher and higher, but my valuation formula kept telling me it was overpriced. I knew that WMT was growing and making money like crazy, but I never connected the dots until I realized that Walmart was a glamour stock and Wall Street's heavy hitters were betting on its future. How could I take that into account?

I created Relative Value, RV, which looks into the future. It answers the question of whether an investment in a stock at its current price is favorable compared to investing in AAA Corporate Bonds over a three year time horizon. If the answer is yes, RV would be greater than 1.00. If the answer is no, RV would be less than 1.00. The mathematical steps we go through to compute RV are itemized in Chapter 6 of my book, "Stocks, Strategies & Common Sense."

Take Tesla (TSLA), the quintessential glamour stock of our time, for example. It closed today at $244.81 per share with a P/E ratio of 165.41. I own it, but would you buy it? I dare say you would not if all you knew were its price and P/E ratio. Jim Cramer is not giving it a buy, buy, buy rating, but he wouldn't sell it short either. Fact is, he doesn't know how to analyze it. RV, however, gives VectorVest users the ability to make a reasonable assessment of Tesla's future prospects which are quite favorable, I might add.

With a forecasted earnings growth rate of 58%/yr., a Relative Safety, RS, rating of 0.97 and a Relative Timing, RT, rating of 1.74, TSLA closed today with an RV rating of 1.44 and a "B" rating. The RV rating of 1.44 says that an investment in TSLA is likely to outperform an investment in AAA Corporate bonds by 44% over the next three years.

Well, how many glamour stocks do we have in our database? I created a search that returned stocks with Price - (Actual) > 2*Value and EPS > 1.00 and ran it as of February 27th's close. A little over 100 stocks were returned. When sorted by RV Desc., only 13 stocks were found to have an RV > 1.00. This shows how difficult it is for a highly overvalued stock to get an RV greater than 1.00. Although many of these stocks are currently rated a "B," I'd be very careful with owning any of these guys with an RV much below 1.00.

I had some fun sorting these stocks in various ways and saw that about half of them were getting a haircut today. It makes me wonder whether they're Bellwether stocks as well as Glamour Stocks.”



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: News Headlines , Earnings , Investing Ideas , Stocks

Referenced Stocks: TSLA , WMT

VectorVest


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