QUESTION: Stock prices are way down from their highs. Is it a good time to buy?- asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.
Answer: You are not the first one to ask the question you just posed. And it is not the first time I have been asked such a question for whenever stock prices drop in a big way.
There is a snooty saying that if you have to ask about the price of a luxury item, then you cannot afford it. In a way, if you have to ask if it is the right time to buy a stock then you probably cannot afford it.
This is because companies, and not just stocks, are bought with something I like to call the K.I.T. currency (i.e. knowledge, investment money and time).
Before a professional investor or trader buys a stock, he would have already conducted his research. Instead of asking if it is the time to buy stocks, he will first figure out if at the current valuation of a company, he can already make his target return given a certain portfolio allocation within his limited investment horizon (whether it is in days, weeks or months for traders or years for investors).
The valuation of a company refers to how investors currently price that company. There are many ways this is done, the most common of which is through measuring a company’s price to earnings ratio or P/E.
P/E ratio
P/E ratio simply shows you how much pesos per share investors are willing to pay for the accounting value of a company’s earnings called earnings per share (EPS).
And if you were to invert the P/E ratio, it translates to its external return on equity (RoE).
So if a company’s price is P100 and its historical EPS is P6.67 then its P/E will be 100 divided 6.67 or 15 times. The external RoE would be 6.67 divided by 100 or 6.67 percent.
The P/E ratio can be based on historical or projected EPS. A similar and some say better valuation is the P/E to Growth or PEG ratio. The PEG ratio takes into account P/E relative to the growth of a company’s EPS, not just to one period’s static earnings.
So if a company’s P/E ratio based on historical EPS is 15 times and its expected EPS growth is 10 percent, that company’s PEG ratio would be computed as 15 divided by 10 (i.e. the decimal value of EPS growth times 100) or 1.5 times.
The rule of thumb is that a stock is ripe for the buying if its PEG ratio is below 1 times. But just like the P/E ratio, you can use the historical average EPS growth or the projected average EPS growth.
Regardless of type of EPS growth, the important thing to remember is that you are consistent on which type you use whenever you are comparing companies to buy.
Critics of the P/E
PEG and internal RoE ratios say that creative accounting can “manufacture” attractive numbers.
At the end of the day, what matters are the growth value that a company’s management creates and the cash that may potentially end up in owner’s pockets in the form of dividends. And for investors like Warren Buffett, the better way is to focus on cash flows that do so.
All of these are just samples of the knowledge needed in the K.I.T. currency. You will still have to figure out your optimal portfolio allocation or the investment amount needed for you to achieve your target return given also your willingness to take risk.
Part and parcel of portfolio allocation is portfolio monitoring, which ranges from performance attribution analysis to measuring risk-adjusted returns.
Then the time you have available for investing has to be blended in to see if you can make your returns within the limits dictated by this precious commodity.
KIT currency
At the end of the day, the question you should be asking is not whether it is the right time to buy but rather if a company is at the right price for you given your limited K.I.T. currency. Otherwise, a stock may not be affordable for you.
If you want to know more about “laymanized” investing, check out the free tools at www.personalfinance.ph. You can also attend our EnRich™ Wealth Creation and Preservation training or our Financial Planner’s Training program for the cities of Mandaluyong, Zamboanga, Baguio, Iloilo, Davao, Cagayan de Oro, Ormoc, and Cebu. Check our website for the details.
(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-5050709 or e-mail to efren@personalfinance.ph. To learn more about value investing strategies, attend the globally recognized Accredited Financial Analyst (AFA) program on Oct 17. For more details, inquire at info@rfp.ph or text <name><e-mail><AFA> at 0917-9689774.