What Goes Up, Doesn't Need To Come Down

People actually attempt to apply the laws of gravity to stocks.  It so drilled into our heads, that what goes up, must come down, people try to apply this physical law to stocks.  A stock can go up, stay up, and then go up some more. 

The amount of terrible advice, and mis-information out there is astounding.  People suggesting to sell, or buy, for all the wrong reasons.  Like I've mentioned before, so much of this game is just keeping an open mind, not allowing yourself to get stuck on one piece of information, and discrediting the nonsense.

You'll hear people say,  "I sold because the stock had run too far", or "I bought because the price has been cut in half."  I'd say about half the people who invest in stocks, never calculate a PE ratio.  It's the only true way to value companies, yet some could care less.  You need to be always evaluating where you stocks are currently.  Just like we talked about in the "Dreaded PE Ratio", keep checking your stocks to see how they are valued.  As the price moves up or down, and as the companies earnings do, that PE will change.

This will sound funny, but these kinds of folks must prefer just to guess if a stock is over, or undervalued.  Wallstreet calls buying a stock after a big upwards run, "chasing".  It calls buying a company where the stock is declining rapidly "catching a falling knife".

The mistakes I see daily in this game are inexcusable.  I'm left stunned that someone who's supposed to be very intelligent, deciding a stock is a sell, for all the wrong reasons, while it's as clear as day to me, the stock is a buy. The reasons why people can be so incorrect on a stock's direction can vary greatly.  With so many factors, reasons for being completely wrong, are easy to find. 

The most glaring reason is the stock action itself.  When you see a successful company's stock, trending higher over a period of years, it's much easier to stay on the bandwagon.  You have been correct for years, all the other investors have been correct also, so who are you come in and spoil their party?  If you are right, and the stock has peaked, and will decline soon, you'll have hundreds of stocks owners telling you just how wrong you are. 

It works the same in reverse.  A stock that has fallen heavily over a period of time, the people that owned the stock and sold it, hate it, because they lost big bucks.  They will trash that stock until the end of time.  The people still in the stock, hate it also, because they are losing money big time.  Then's there's a select few, that have taken the losses, but still believe in the underlying company.   When a new buyer like yourself, come in and decides this stock has fallen too far, maybe the business prospects changed, or the valuation has gotten too cheap, understand that most people will call you crazy.

Going against the grain is necessary, and very profitable.  You need to be agnostic towards the stock, and company.  This is where good traders make their money.  Greed, Stubborness, Denial, are all human emotions, and when applied to the stock market, will lose you money. It counter-intuative, but it's usually when the naysayers are the loudest, that your buy, or sell call, will be the most correct.

Let me tell you why "Stocks Are Leading Indicators"...

The Dreaded PE Ratio

The amount of shares outstanding varies from business to business.  One company might have 1 million shares outstanding, while the next, 1 billion.  Not only that, the float size can change at any time, depending on the company's actions.  They might sell more shares into the market to raise money, or decide to buy back shares to shrink the float, and increase Earnings Per Share (EPS).  Sometimes companies do "splits" and "reverse-splits" which restructure the float, and share structure.

The amount of shares outstanding, is simply the amount of pieces a business has been broken into.  In the example above, the billion dollar company has been split into a billion pieces.  That's 1000 times more shares than the company with a float of one million shares.

How do we then compare these companies Apples to Apples?  We use a "PE Ratio", or a price-to-earnings ratio.  This ratio allows us to see the company for what it earns, per share outstanding, and factors the current price of the stock.  Sometimes, people call the PE, the "multiple".

Basically the ratio, takes the "Price" of the stock, and divides it by the "EPS".  You can calculate the earnings per share for any company, by taking their total income for the year, and dividing it by the amount of shares outstanding.  This will get you the "Earnings" for the stock.  You can then take the price the stock is currently trading at, and divide by the EPS, and come up with a PE ratio.

This is exactly why the price of a stock has almost zero value.  You can't look at a stock like Apple trading around $440, and call it expensive.  Tomorrow Apple could do a 10-1 share split, increase their float tenfold, but the share price going forward would only be $44 each. 

Buying Apple at $440 with a billion shares outstanding, is the same as buying it at $44, with 10 billion shares outstanding.  The price may seem more attractive, but both buys are exactly the same.  Sure, you can buy 10 times more shares at $44, but there's also 10 times as many shares out there.

You can't just compare EPS to EPS, because we'd be completely ignoring what price the stock is currently trading at.  The last step, dividing the Price by the EPS gets you a PE ratio, which will factor the price the stocks are trading at, as well.

If your calculations lead you to conclude that Apple is trading at a 16 PE, and MSFT is trading at a 12 PE.  You can say for certain that MSFT is cheaper than Apple at that point in time, assuming earnings projection for the year are accurate.  In some cases, you'd buy MSFT because it was a better value. Other times, it's okay to pay more for a better quality stock, with better growth options if that's what you decide makes sense.

Different sectors, and different size companies have a different baseline, for what is a usual PE for that "group" of similar stocks.  Safe, establish companies might only warrant a 10-12 PE due to slowing growth.  A small cap tech stock,  with a hot story, might warrant a PE of 100.

There is a ton more about PE's I can't discuss in this blog post.  Understand one thing about PE's though, they are subject to interpretation.  PE's make the market.  Usually at what growth rate a stock has, has a big impact over what PE it deserves.  In the end, the market will decide what fair PE is for certain stock in certain sectors.

The winners in each sector always deserve a premium to the rest of their group, because that business has superior earnings, and prospects.  The best companies, in their respected sectors, are called "Best Of Breed".  If you see a best of breed company, trading in line with it's pears, after previously out performing, check out their core business.  If they truly are a better company, it's might be just the time to snatch them up.

Time to bend the laws of gravity, in "What Goes Up, Doesn't Need To Come Down"...