Non-Market Risk and a Concentrated Portfolio

Holding a concentrated portfolio is not as risky as one may think.

Just holding 2 stocks instead of 1, eliminates 46% of your unsystemic risk.

Holding only 8 stocks will eliminate about 81% of your diversifiable risk.


What about the range of returns?

Average return of the stock market during one period examined was about 10%.

Statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between -8% and +28% about two-thirds of the time.  One-third of the time, the returns fell outside this 36-point range.

If your portfolio is limited to only 5 stocks, the expected return remains 10%, but your one-year range expands to between -11% and +31% about two-thirds of the time.

If there are 8 stocks, the range is between -10% and +30%.


Conclusion

It takes fewer stocks to diversify a portfolio than one might intuitively think.

Circle of Competence and Sector Concentration.

If you are investing within your cicle of competence, your stock selections will gravitate toward certain sectors and investment styles.

Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses.

Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio.

Portfolio Weighting

It is important to know:

1.  how many stocks to own in your portfolio, and also,
2.  the percentage of your portfolio occupied by each stock.

A good investor has a knack for having a greater percentage of their money in stocks that do well and a lesser amount in their bad picks.


How does he do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick.

If you have a lot of confidence in the long term outlook and the valuation of a stock, it should be weighted more heavily than a stock than a stock you may be taking a flier on.


Weight your portfolio wisely.

Don't be too afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about.

Of course, do not go off the deep end by having, for example, 50% of your portfolio in a single stock.



Additional notes:

If a stock has a 10% weighting in your portfolio, then a 20% change in price will move your overall portfolio 2%.

If a stock has only a 3% weighting, a 20% price change has only a 0.6% effect on your portfolio.

The Appropriate Attitude towards Market Prices

Once Mr. Buffett has decided that he is competent to evaluate a company, that the company has sustainable advantages and that it is run by commendable managers, then he still has to decide whether or not to buy it.



To buy or not to buy:  This step is the most crucial part of the process.

The decision process seems simple enough:  If the market price is below the discounted cash flow calculation of fair value, then the security is a candidate for purchase.

The available securities that offer the greatest discounts to fair value estimates are the ones to buy.

However, what seems simple in theory is difficult in practice.

• A company's stock price typically drops when investors shun it because of bad news.  So a buyer of cheap securities is constantly swimming against the tide of popular sentiment.
• Even investments that generate excellent long-term returns can perform poorly for years.  [In fact, Buffett wrote an article in 1979 explaining that stocks were undervalued, yet the undervaluation only worsened for another three years.]
• Most investors find it difficult to buy when it seems that everyone is selling and difficult to remain steadfast when returns are poor for several consecutive years.

The appropriate attitude toward market price

Buffett credits his late friend and mentor, Benjamin Graham, with teaching him the appropriate attitude toward market prices.

Graham's parable:  "Imagine the daily quotations as coming from Mr. Market, your very temperamental partner in a private business.  Each day he offers you a price for which he will buy your share of the business or for which you can buy his share of the business.  On some days he is euphoric and offers you a very high price for your share.  On other days he is despondent and offers a very low price.  Mr. Market doesn't mind if you abuse or ignore him - he will be back with another price tomorrow."




The most important thing to remember about Mr. Market.

He offers you the potential to make a profit, but he does not offer useful guidance.

If an investor cannot evaluate his business better than Mr. Market, then the investor doesn't belong in that business.

Thus, Buffett invests only in predictable businesses that he understands, and he ignores the judgement of Mr. market (the daily market price) except to take advantage of Mr. Market.

Wide Moat Companies: Fat Pitch Approach and Low Turnover of Portfolio.

Fat Pitch method.

Great companies (wide-moat) selling at a discount are rare. So when you find one, you should pounce.

Over the years, a wide-moat company will generate returns on capital higher than its cost of capital, creating value for shareholders.

 This shareholder value translates into a higher stock price over time.




Move In and Out of Wide-Moat Stocks

IF YOU SELL AFTER MAKING A SMALL PROFIT, you might not get another chance to buy the stock, or a similar high-quality stock, for a long time.

For this reason, it is irrational to quickly move in and out of wide-moat stocks and incur transactions costs ( and also capital gain taxes in some countries).

 Your results after trading expenses (and taxes), likely won't be any better and may be worse.




Low Turnover

That is why many of the great long-term investors display low turnover in their portfolios.

 They have learned to LET THEIR WINNERS RUN AND TO THINK LIKE OWNERS, NOT TRADERS.

Stocks are ownership interests in companies.

Being a stockholder is being a partial owner of a company.

Over the long term, a company's business performance and its stock price will converge.

The market rewards companies that earn high returns on capital over a long period.

Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital.

The wealth a company creates - as measured by returns on capital - will find its way to shareholders over the long term in the form of dividends or stock appreciation.



My favourite financial ratios: ROA, ROE and ROIC.

Using Earnings Power Value (EPV) to weigh up the value of a share

Earnings Power Value (EPV) is another way to weigh up the value of a share.

EPV gives you an estimated value of a share if its current cash profits stay the same forever.



Calculating EPV

This is how you calculate it.

1.  Take a company's normalised or underlying trading profits or EBIT.

2.  Add back depreciation and amortization.

3.  Take away stay in business capex.

4.  Tax this cash profit number by the company's tax rate.

5.  Divide by a required interest rate# to get an estimate of total company or enterprise value.

6.  Take away debt, pension fund deficit, preferred equity and minority intersts to get a value of equity.  Add any surplus cash.

7.  Divide by the number of shares in issue to get an estimate of EPV per share.



#What interest rate should you use when valuing a business?

All you need to know is that the higher the interest rate you use, the more conservative your estimate of value will be.

Here are some rough and ready guidelines of the interest rates you might want to use when valuing different companies:

• Large and less risky companies:  7% to 9%
• Smaller and more risky (lots of debt or volatile profits):  10% to 12%
• Very small and very risky:  15% or more.

Compare your estimate of EPV per share with the current share price.  

1.   Current Share Price > EPV

For example:
                      EPV per share                    151.4
                      Current Share Price            320 

We can see that the estimate of EPV accounts for less than half of the existing share price.

• A large chunk of the current 320 price is based on the expectation of future profit growth.  

2.   Current Share Price < EPV

EPV can be a great way of spotting very cheap shares. 

Sometimes it is possible to find shares which are selling at a significant discount to their EPV.

• When you come across a share like this, you need to spend time considering whether its current profits can stay the same, or whether they are likely to fall.  
• If profits are likely to fall, it might be best to move on and start looking at other shares.

To minimise the risk of overpaying for a company's shares, you should try to buy when its current profits - its EPV - can explain as much of the current share price as possible.

• As a rough rule of thumb, even if profits and cash flows have been growing rapidly, do not buy a share where more than half its share price is reliant on future profits growth.  

An example of how to calculate EPV

Company ABC  Earnings Power Value ($m)

Underlying EBIT                                      73.6
Dep & Amort                                              6.6
Stay in business CAPEX                           -8.9
Cash trading profit                                    71.3
Tax @ 20%                                              -14.3
After tax cash profits (A)                       57.0
Interest rate (B)                                        8%
EPV = A/B                                                713

ADJUSTMENTS
Net debt/net cash                                      40.4
Preference Equity                                          0
Minority interests                                          0
Pension fund deficit                                       0
Equity value                                          753.4
Shares in issue (m)                                497.55
EPV per share (cents)                           151.4

Current share price (cents)                         320
EPV as % of current share price                47.3%
Future growth as % of current share price 52.7%

Buying a home? Be financially mindful.

Excellent podcast.
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Presented by: Tan Chung Han

Tags: Mortgage, Debt, Home, House, Rent, Freehold, Leasehold, Property, Financial Services, Personal Finance

How to be successful in using technical analysis

To be successful, the technical approach involves taking a  position contrary to the expectation of the crowd.

This requires the patience, objectivity and discipline to acquire a financial asset at a time of depression and gloom, and liquidate it in an environment of euphoria and excessive optimism.

The level of pessimism or optimism will depend on the turning point.

Short-term peaks and trough are associated with more moderate extremes in sentiment than long-term ones.

Knowing the technical characteristics to be expected at all of these market turning points, particularly the major ones, allow you to assess them objectively.





Technical analysis in Practice

In practice, it is impossible to buy and sell consistently at exactly the turning points, but the enormous potential of this approach still leaves plenty of room for error, even when commission costs and taxes are included in the calculation. 

The rewards for identifying major market junctures and taking the appropriate action can be substantial.

In the days of the old market, participants had a fairly long time horizon, stretching over months or years.  There have always been short-term traders and scalpers, but the technological revolution in communications has shortened the time horizon of just about everyone involved in markets.

When holding periods are lengthy, it is possible to indulge in the luxury of fundamental analysis, but when time is short, timing is everything.  In such an environment, technical analysis really comes into its own.

Originally, technical analysis was applied principally in the equity market, but its popularity has gradually expanded to embrace commodities, debt instruments, currencies, and other international markets.

Technical Analysis Defined

The technical approach to investment is essentially a reflection of the idea that prices move in trends that are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces.

The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.  The evidence in this case is represented by the numerous scientifically derived indicators.

Human nature remains more of less constant and tends to react to similar situations in consistent ways.  By studying the nature of previous market turning pints, it is possible to develop some characteristics that can help to identify market tops and bottoms.  

Therefore, technical analysis is based on the assumption that people will continue to make the same mistakes they have made in the past.  

Human relationships are extremely complex and never repeat in identical combinations.  The market,s which are a reflection of people in action, never duplicate their performance exactly, but the recurrence of similar characteristics is sufficient to enable technicians to identify juncture points.  

Since no single indicator has signaled, or indeed could signal, every top or bottom, technical analysis have developed an arsenal of tools to help isolate these points.

A study of the market can also reveal much about human nature, both from observing other people in action and from the aspect of self-development.

There is no reason why anyone cannot make a substantial amount of money in the financial markets, but there are many reasons why many people will not.

The key to success is knowledge and action.  

• Knowledge of the internal working of the markets and of investing is important.  
• Action is dependent on the patience, discipline and objectivity of the individual investor. 

Today, numerous charting sites have sprung up on the Internet, so virtually anyone now has the ability to practice technical analysis.  As a consequence of the technological revolution, time horizons have been greatly shortened.

• This may not be a good thing because short-term trends experience more random noise than longer-term ones.  
• This means that the technical indicators are not as effective.

Nothing has really changed in the last 100 years.  The same true and tried principles in technical analysis are as relevant today as they always were.  There is no doubt whatsoever that this will continue to be so in the future.

• Thus, technical analysis could be applied in New York in 1850, in Tokyo in 1950 and in Moscow in 2150.  
• This is true because price action in financial markets is a reflection of human nature, and human nature remains more or less constant.  
• Technical principles can also be applied to any freely traded entity in any time frame.  
• A trend reversal signal on a 5-minute bar chart is based on the same indicators as one on a monthly chart; only the significance is different.  Shorter time frames reflect shorter trends and are therefore less significant.   

Since the 1970s, the time horizon of virtually all market participants has shrunk considerably.

• As a result, technical analysis has become very popular for implementing short-term timing strategies.  
• This use may lead to great disappointment.

There is a rough correlation between the reliability of the technical indicators and the time span being monitored.

• Even short-term traders with a 1- to 3-week time horizon need to have some understanding of the direction and maturity of the main or primary trend.  
• This is because mistakes are usually made by taking on positions that go against the direction of the main trend.  
• If a whipsaw is going to develop, it will usually arise from a contra-trend signal.

To be successful, technical analysis should be regarded as the art of assessing the technical position of a particular security with the aid of several scientifically researched indicators. 

• Although many of the mechanistic techniques offer reliable indications of changing market conditions, all suffer from the common characteristic that they can, and often do, fail to operate satisfactorily.  
• This attribute present no problem to the consciously disciplined investor or trader, since a good working knowledge of the principles underlying major price movements in financial markets and a balanced view of the overall technical position offer a superior framework within which to operate.  

There is no substitute for independent thought.

• The action of the technical indicators illustrates the underlying characteristics of any market and it is up to the analyst to put the pieces of the jigsaw puzzle together and develop a working hypothesis.
• The task is by no means easy, as initial success can lead to overconfidence and arrogance.  

"Pride of opinion caused the downfall of more men on Wall Street than all the other opinions put together."  Charles H. Dow, the father of technical analysis.

This is true because markets are essentially a reflection of people in action.

• Normally, such activity develops on a reasonably predictable path.  
• Since people can and do change their minds, price trends in the market can deviate unexpectedly from their anticipated course.  
• To avoid serious trouble, investors, and especially traders, must adjust their attitudes as changes in the technical position emerge.

A study of the market can also reveal much about human nature, both from observing other people in action and from the aspect of self-development.  

• As investors react to the constant struggle through which the market will undoubtedly put them, they will also learn a little about their own makeup.  

"Little minds are taxed and subdued by misfortune but great minds rise above it."  Washington Irving.



Martin J. Pring
Technical Analysis Explained

Investing basics: Key constituents of an annual report

An annual report is probably among the most viewed company publications. It is the most comprehensive means of communication between a company and its shareholders. It is a report that each company must provide to each of its shareholder at the end of the financial year. To put it differently, it is a report that each shareholder must read.

But what is its use if one does not understand or refer to it?


As a shareholder of a company, you need to know its performance over the past financial year and the management's view on the same. You also need to know what is the company's future plan and strategies. As a shareholder, you need to know what does the management intends to do to attain those targets.

We present to you a brief on what the key constituents of an annual report are.

Key constituents of an Annual Report

Director's report: The director's report comprises the events that take place in the reporting period. This includes a summary of financials, analysis of operational performance, details of new ventures and business, performance of subsidiaries, details of change in share capital, and details of dividends. In short, shareholders can get a gist of the fiscal year from this section.

Management discussion and analysis (MD&A): More often than not, the MD&A starts off with the management giving its view on the economy. It is then followed by a perspective on the sector in which the company is present. Any major changes like inflation, government policies, competition, tax structures, amongst others are highlighted and discussed in this report. It also includes the business strategy the management intends to follow. Details regarding different segments are provided in this section. The company also gives a brief SWOT (strength, weakness, opportunity, and threat) analysis and business outlook for the coming fiscal.

This can aid the shareholder to understand what major changes are likely to affect the company going forward. However, as mentioned earlier, an investor should not blindly believe what the management has to say. While it tends to paint a rosy picture, one needs to judge the sanity behind the rationale.

Report on corporate governance: The report on corporate governance covers all aspects that are essential to the shareholder of a company and are not part of the daily operations of the company. It includes details regarding the directors and management of a company. These include details such as their background and their remuneration. This report also provides data regarding board meetings - how many directors attended the how many meetings. It also provides general shareholder information such as correspondence details, details of annual general meetings, dividend payment details, stock performance, details of registrar and transfer agents and the shareholding pattern.

Financial statements and schedules: Finally, we arrive at the crux of the annual report, the financial statements. Financial statements, as you are aware, provide details regarding the operational performance of a company during the reporting period. In addition, it also depicts the financial strength of a company. The key constituents of the financial statement include the profit and loss account, the balance sheet, the cash flow statement and the schedules.



This article is authored by Equitymaster.com, India’s leading independent equity research initiative

https://premium.thehindubusinessline.com/portfolio/beyond-stocks/investing-basics-key-constituents-of-an-annual-report/article23153778.ece

Managing Risks and Benefiting from Risks

Risks


There are numerous risks involved in investing in the stock market.
- Knowing that these risks exist should be one of the things an investor is constantly aware of.
- The money you invest in the stock market is not guaranteed.


For instance, you might buy a stock expecting a certain dividend or rate of share price increase.
- If the company experiences financial problems it may not live up to your dividend or price growth expectations.
- If the company goes out of business you will probably lose everything you invested in it.
- Due to the uncertainty of the outcome, you bear a certain amount of risk when you purchase a stock.


Stocks differ in the amount of risks they present.
- For instance, Internet stocks in 2000 have demonstrated themselves to be much more risky than utility stocks.


One risk is the stocks reaction to news items about the company.
- Depending on how the investors interpret the new item, they may be influenced to buy or sell the stock.
- If enough of these investors begin to buy or sell at the same time it will cause the price to rise or fall.



Managing risks

One effective strategy to cope with risk is diversification.
- This means spreading out your investments over several stocks in different market sectors.
- Remember the saying: “Don’t put all your eggs in the same basket”.


As investors we need to find our “Risk Tolerance”.
- Risk tolerance is our emotional and financial ability to ride out a decline in the market without panicking and selling at a loss.
- When we define that point we make sure not to extend our investments beyond it.


Benefiting from risks

The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy.
- It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!


The Internet has make investing in the stock market a possibility for almost everybody.
- The wealth of online information, articles, and stock quotes gives the average person the same abilities that were once available to only stock brokers.
- No longer does the investor need to contact a broker for this information or to place orders to buy or sell.
- We now have almost instant access to our accounts and the ability to place on-line orders in seconds.
- This new freedom has ushered in new masses of hopeful investors.


Still this in not a random process of buying and selling stock. We need a strategy for selecting a suitable stock as well as timing to buy and sell in order to make a profit.

Bull Market – Bear Market

1.  Bull Market and Bear Market. What do they mean?

(a)  What is a bull market?

A bull market is defined by steadily rising prices. 

The economy is thriving and companies are generally making a profit.

Most investors feel that this trend will continue for some time.


(b)  What is a bear market?

By contrast a bear market is one where prices are dropping. 

The economy is probably in a decline and many companies are experiencing difficulties.

Now the investors are pessimistic about the future profitability of the stock market.

Since investors’ attitudes tend to drive their willingness to buy or sell these trends normally perpetuate themselves until significant outside events intervene to cause a reversal of opinion.



2.  Investing in a bull market

In a bull market the investor hopes to buy early and hold the stock until it has reached it’s high.

Obviously predicting the low and high is impossible. 

Since most investors are “bullish” they make more money in the rising bull market.

They are willing to invest more money as the stock is rising and realize more profit.



3.  Investing in a bear market

Investing in a bear market incurs the greatest possibility of losses because the trend in downward and there is no end in sight.

An investment strategy in this case might be short selling. 

Short selling is selling a stock that you don’t own.

You can make arrangements with your broker to do this.

You will in effect be borrowing shares from your broker to sell in the hope of buying them back later when the price has dropped.

You will profit from the difference in the two prices. 

Another strategy for a bear market would be buying defensive stocks. 

These are stocks like utility companies that are not affected by the market downturn or companies that sell their products during all economic conditions.

Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/


This article was first posted on 24.11.2011.

Are you interested in investing into Dutch Lady?

The Greatest Cash Flow Machine in the History of Capitalism

Stansberry Investment Hour

Warren Buffett Says, "I'm Buying Stocks".

@1.00 min to 1.39 min

I am buying stock and I am not buying because I think the stock is going up next year.

I am buying because I think the stock will be worth a bit more money 10 or 20 years from now.

I don't know whether they are going to go up or down tomorrow, next week, next  month or next year.

I do know good business is, in relation .... you have to measure investments in relation to each other.... and the alternative for most people it is fixed income and you get 3.02% or something like that for 30 years.

So, would you be better to invest in a company that is earning 15 to 20% on the invested capital and compound it or have a 3% bond which can never earn more than 3% while you own it?

Dividend Yield Theory - Buying and Selling tied to the Underlying Yield

THE DIVIDEND-YIELD THEORY:  BUYING AND SELLING ARE TIED TO THE UNDERLYING YIELD

UNDERVALUE – YIELD IS HIGH AND PRICE IS LOW

OVERVALUE – YIELD IS LOW AND PRICE IS HIGH


http://www.betterinvesting.org/NR/rdonlyres/837880CD-BF8D-41C8-8C38-033ECA4643F5/0/DividendsStillDontLie.pdf

Should You Sell Company ABC At This PE Ratio of 36.4x?

Should You Sell Company ABC At This PE Ratio?


ABC is trading with a trailing P/E of 36.4x, which is higher than the industry average of 23.5x.

• While ABC might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 
• You should understand what the P/E ratio is, how to interpret it and what to watch out for. 

1.   Breaking down the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 

• By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for ABC

Price-Earnings Ratio = Price per share ÷ Earnings per share



On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies.

• Your goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ABC, such as company lifetime and products sold. 
• A quick method of creating a peer group is to use companies in the same industry. 
• ABC’s P/E of 36.4x is higher than its industry peers (23.5x), which implies that each dollar of  ABC’s earnings is being overvalued by investors. Therefore, according to this analysis, ABC is an over-priced stock.

2.  Assumptions to watch out for

Before you jump to the conclusion that ABC should be banished from your portfolio, it is important to realise that your conclusion rests on two assertions. 

(a)  Firstly, your peer group contains companies that are similar to ABC.

• If this isn’t the case, the difference in P/E could be due to other factors. 
• For example, if you compared lower risk firms with ABC, then investors would naturally value it at a lower price since it is a riskier investment. 

(b)  The second assumption that must hold true is that the stocks we are comparing ABC to are fairly valued by the market.

• If this is violated, ABC’s P/E may be lower than its peers as they are actually overvalued by investors.

3.   What this means for you:


(a)  Are you a shareholder? 

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to ABC.

Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.


(b)  Are you a potential investor? 

If you are considering investing in ABC, looking at the PE ratio on its own is not enough to make a well-informed decision.

You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. 

Another limitation of PE is it doesn’t properly account for growth, you can use a list of stocks with a high growth potential and see if their PE is still reasonable.




The thought process using Relative Valuation

Price based on past earnings
PE 36.4x
ABC is overvalued based one earnings compared to the industry average.
ABC is overvalued based on earnings compared to the local market.


Price based on expected growth
PEG 3.0x
ABC is poor value based on expected growth next year.


Price based on value of assets
P/B 15.3x
ABC is overvalued based on assets compared to the industry average