Saturday, August 27, 2011

Lesson 6: Never Overpay for a Company

In our previous lesson on the magic formula, we mentioned that a low PE Ratio was part of the formula. This is the explanation of why it is the case. It sounds obvious, but there is a difference between a good company and a good stock. You may buy into a good company but lose money because the stock is not good. I'll give you a good recent example.
Netflix is a viable company. It sells a product that people want. It has a business model that works. And it is earning money. The stock however, is a different story. It is too expensive. I don't mean the price of a share, but the price to earnings ratio.

In my grocery store example, we looked at how to compare a company's earnings to the interest rate of a savings account. At a price of 221.89 right now, and 2.89 per share as 2010's earnings, NFLX has a PE ratio of 76.78. PE ratios are extremely valuable as they can give us a quick idea of an equivalent interest rate. To do this, do 1 / 76.78 = 1.3%. At a price of 221.89, we are getting approximately 1.3% interest on our money. This is very unattractive to me. I want a margin of error, so that even if I'm wrong, I won't be hurt that badly. I'd like to get into NFLX at a PE no higher than 15, lower if possible. This means I wouldn't get into NFLX at its current earnings unless it was 43.35, or 15 * 2.89. At 43.35, NFLX might be worth buying. If it actually came closer to that level, I would do more research to see if there are any hidden time bombs. At its current price, it's not worth spending the time to do the research yet.

PE ratio in essence, is what tells you whether or not a stock is too expensive. However, a PE ratio is not a perfect measure of this. You need to understand that a non-normal year will drastically change the PE. For example, if a company sells a subsidiary, it will record an unusual profit or loss. This is something that is not likely to happen again, but it can put a very noticeable spike into the PE ratio. For example, if NFLX sold a subsidiary and took a 2.80 per share loss for 2010, it would have an earnings per share of 0.09. At a price of 211.89, this would cause the PE ratio to be 2354. This is non-nonsensical. You will need to make some kind of adjustment or judgement go obtain a more meaningful number. We won't cover that in this post yet.

For simple companies that do the same thing every year and don't participate in many acquisitions and large asset sales, the PE ratio is a very good criteria for a stock screener. This will give us a list of companies that are much more likely to be good stocks. However, keep in mind how the PE ratio can sometimes be misleading or not make sense. Finding a good stock does not stop at the PE ratio. Strive to find a good company which also has a good stock that you can buy.

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