A Good Company with a Bad P/E

Attractive Stock

Naturally, investors want aboard this gravy train. To find a seat, they are willing to pay a premium.

There is nothing wrong with wanting a piece of this type of company.

The problem comes when you are a late arrival and the price of admission (stock price) has climbed too high.

How high is too high?

That’s a question that every investor must asked and answer.

Too often, investors jump when they should stand back and take a hard look.

Investors who have a chance for success look for good companies, companies like Acme Cumquats that have superior management and consistently throw off earnings quarter after quarter.

But that is only half the work needed to find a good investment.

Good Company, Good Investment

For a good company to be a good investment, it must be priced (valued) correctly.

Investors gain from a stock investment by buying at a price that is below the actual value. Over time, a good company will reward the investor with dividends and growth in the stock’s price.

If that is all there was, valuation would be much easier. However, there is another factor to consider.

Investors eager to get a piece of the action may bid up the stock’s price to a level where future price appreciation is uncertain.

Ignoring dividends for a minute, you can get a rough idea of valuation by multiplying the earnings per share (EPS) by the price earnings ratio (P/E).

P/E Factor

Remember P/E is a factor of how much investors are willing to pay for earnings.

So if a company is earning $2 per share and the P/E is 25, the stock should be worth $50 per share. If earning don’t change, but the P/E drops to 20 (meaning investors are not so excited about the company’s future prospects), the stock should now be worth $40 per share.

This is the problem of paying too much for the stock - if investor sentiment turns - the stock falls. Investors can’t predict what the market will do and how that might influence the stock’s price. Focusing on buying a stock at a discount to its worth as an operating company will help protect you from speculative influences on market price.

Of course, P/E is not the only or even the best measure of a stock’s true value, but it does illustrate why buying high is a dangerous strategy. (By Ken Little)