So if a company is reporting a
profit of $2 per share, and the stock is selling for $20 per share, the P/E is
10. In other words you are paying ten-times earnings.
P/E Ratio = Price Per Share / Annual
Earnings per Share
A favourite tool of the contrarian is the
price/earnings ratio (P/E), which is calculated by dividing the current share
price in cents by the company's earnings per share, or EPS. Thankfully, the historic
P/E on stocks is readily available, so you don't have to manually do this
The P/E ratio is rather useless on its own, but is a handy comparison tool. You
can use it to compare one company against its peers, to the overall market, or
sector, as well as to track historic performance.
Let's say that one company (Company A) has a P/E of 12 and another company in
the same industry (Company B) sports a P/E of 20. For every $1 of current
earnings, the investor is effectively paying $12 a share for Company A and $20
a share for Company B.
It's clear that Company A is cheaper than Company B because for every $1 of
earnings, you're paying $12 a share instead of $20.
Contrarian investors use this as a guide for finding stocks that are going
cheap. They particularly like stocks that are trading on a low P/E relative to
their peers and the overall market.
But does that mean that Company A is a better buy than Company B?
As we all know, earnings are the basic ingredients of share price growth, and
the best stocks to buy are those exhibiting a trend of increasing earnings (we
like to see earnings growth for five years or longer). Remember, earnings refer
to "net profits" and not revenue.
When investors spot a company with a trend of increasing earnings, they get
excited and buy shares. As more shares are purchased, the share price is bid
up, and so is the P/E ratio (since the current share price is the numerator in
the ratio). The more popular the stock, the higher its P/E.
So Company B could in fact be a better buy than Company A if its earnings are
growing at a faster pace.
There are times however when markets get out of wack. External shocks such as
the recent financial crisis send share prices into a spin, and stocks that were
once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.
It's times like these that contrarian or value investors come to the fore. With
their toolkit in hand, bargain hunters set to work.
A bargain means that you are getting something that should cost $10, for $5.
You buy a leather couch on special for $2,000 that a week prior was holding a
price tag of $4,000. This is what most of us call a true bargain without
thinking too much about it.
But just because the coach was priced at $4,000 the week prior, doesn't
necessarily mean that it's a bargain at $2,000. (It could be old stock, its
design could be going out of fashion).
Likewise, just because your favourite stock was trading at a P/E of 10 many
months ago, doesn't necessarily mean that it's a steal at 6 today. Basically
you have to consider whether the fundamentals have changed.
For example, as consumers tighten their purse strings, will the company
struggle to sell its goods and services? If the company has a lot of debt on
its books, will it battle to get funding? If it's an importing company, will
the fall in the AUD/USD impact its sales?
Sometimes a fall in the P/E can be justified, sometimes not. And getting this
right is the true test of whether a contrarian investor spots a bargain or not.
ii. Cash Rate
What does it mean?
The cash rate is the interest rate
financial institutions pay to borrow or charge to lend funds in the money
market on an overnight basis. The Reserve Bank of Australia uses a narrower
definition of the cash rate as an operational target for the implementation of
monetary policy. The Reserve Bank of Australia's measure of the cash
rate is the interest rate which banks pay or charge to borrow funds from or
lend funds to other banks on an overnight unsecured basis. This measure is also
known as the interbank overnight rate. The Reserve Bank of Australia
calculates and publishes this cash rate each day on the basis of data collected
directly from banks. This measure of the cash rate has been published by the
Reserve Bank of Australia
since June 1998.
Share market investors also have to keep a
close eye on Reserve Bank announcements. Any rate change by the Reserve will
flow through to the money markets immediately via a move in the cash rate but
stocks will also rise or fall as strategists assess whether shares are more
attractive investments than cash and bonds. Analysts will feed rate changes
into their modeling to work how out companies will be affected by borrowing
costs as well as the impact of changed consumer behaviour and discretionary
spending and this can quickly flow through to share prices.
Anyone investing over a five-to-seven year period will
see major changes in interest rates and investors need to know where we are in
the interest rate cycle for an indication of where the stock market is headed.
Investors should be reading the Reserve's statements and announcements for
pointers to its thinking on the economy and what action it might take on rates.
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