How to Weed Out the Losers in a Group
Insisting on three years of earnings growth will help you quickly weed out
80% of the stocks in any industry group. Growth rates for most stocks in
most groups are lackluster or nonexistent—unlike, for example,
• Xerox, which was growing at a 32% annual rate before its shares soared
700% from March 1963 to June 1966
• Wal-Mart Stores, which consistently created an annual growth rate of
43% before rocketing 11,200% from 1977 to 1990
• Cisco Systems, whose earnings were exploding at a 257% rate in October
1990, and Microsoft, which was growing at a 99% clip in October 1986,
before their enormous advances
• Priceline.com, which from 2004 to 2006 more than doubled its earnings
from 96 cents a share to $2.03, before it tripled in price in the next five
quarters
• Google, which had already expanded its earnings from 55 cents a share in
2002 to $2.51 a share in 2004 before its stock climbed from $200 to $700
by 2007
Keep in mind that an annual growth record doesn’t necessarily make a
company a solid growth stock. In fact, some so-called growth stocks report
substantially slower growth than they did in earlier market periods. Many
growth leaders in one cycle do not repeat in the next cycle.
The stock of a company that has an outstanding three-year growth record
of 30% but whose earnings growth has slowed to 10% or 15% in the last sev-
eral quarters acts like a fully mature growth stock. Older and larger organiza-
tions are usually characterized by slower growth, and many of them should be
avoided. America is continually led and driven by new innovative entrepre-
neurial companies. They, and not our government, create our new industries.
Insist on Both Annual and Current Quarterly Earnings Being Excellent
A standout stock needs both a sound growth record in recent years and a
strong current earnings record in the last several quarters. It’s the powerful
combination of these two critical factors, rather than one or the other, that
creates a super stock, or at least one that has a higher chance for true success.
The fastest way to find a company with strong and accelerating current
earnings and solid three-year growth is by checking the proprietary Earn-
ings per Share (EPS) Rating provided for every stock listed in Investor’s
Business Daily’s research stock tables.
The EPS Rating measures a company’s two most recent quarters of
earnings growth against the same quarters the year before and examines
its growth rate over the last three years. The results are then compared
with those of all other publicly traded companies and rated on a scale
from 1 to 99, with 99 being best. An EPS Rating of 99 means a company
has outperformed 99% of all other companies in terms of both annual and
recent quarterly earnings performance.
If the stock is newly issued and the company doesn’t have a three-year
earnings record, look for big earnings increases and even bigger sales
growth over the last five or six quarters. One or two quarters of profitability
are often not enough and indicate a less-proven stock that might fall apart
somewhere down the line.
Are Price/Earnings Ratios Really Important?
If you’re like most investors, you’ve probably learned the most important
thing you need to know about a stock is its P/E ratio. Well, prepare yourself
for a bubble-bursting surprise.
For years, analysts have used P/E ratios as their basic measurement tool in
deciding whether a stock is undervalued (has a low P/E) and should be bought,
or is overvalued (has a high P/E) and should be sold. But our ongoing analysis
of the most successful stocks from 1880 to the present shows that, contrary to
most investors’ beliefs, P/E ratios were not a relevant factor in price movement
and have very little to do with whether a stock should be bought or sold.
Much more crucial, we found, was the percentage increase in earnings
per share. To say that a security is “undervalued” because it’s selling at a low
P/E or because it’s in the low end of its historical P/E range can be nonsense.
Primary consideration should be given to whether the rate of change in earnings
is substantially increasing or decreasing.
From 1953 through 1985, the average P/E ratio for the best-performing
stocks at their early emerging stage was 20. (The average P/E of the Dow
Jones Industrials over the same period was 15.) As they advanced, the biggest
winners expanded their P/Es by 125%, to about 45. From 1990 to 1995, the
real leaders began with an average P/E of 36 and expanded into the 80s. But
these were just the averages. Beginning P/Es for most big winners ranged
from 25 to 50, and the P/E expansions varied from 60 to 115. In the market
euphoria of the late 1990s, these valuations increased to even greater levels.
Value buyers missed almost all of these tremendous investments.
Why You Missed Some Fabulous Stocks!
These findings strongly suggest that if you weren’t willing to buy growth
stocks at 25 to 50 times earnings, or even much more, you automatically
eliminated most of the best investments available! You missed Microsoft,
Cisco Systems, Home Depot, America Online, and many, many others dur-
ing their periods of greatest market performance.
Our studies suggest P/E ratios are an end effect of accelerating earnings
that, in turn, attract big institutional buyers, resulting in strong price per-
formance. P/Es are not a cause of excellent performance. High P/Es, for
example, were found to occur because of bull markets. Low P/Es, with the
exception of those on cyclical stocks, generally occurred because of bear
markets.
In a roaring bull market, don’t overlook a stock just because its P/E seems
too high. It could be the next great winner. And never buy a stock just
because the P/E ratio makes it look like a bargain. There are usually good
reasons why the P/E is low, and there’s no golden rule that prevents a stock
that sells at 8 or 10 times earnings from going even lower and selling at 4 or
5 times earnings.
Many years ago, when I first began to study the market, I bought
Northrop at 4 times earnings and watched in disbelief as the stock declined
to a P/E ratio of 2.
How Price/Earnings Ratios Are Misused
Many Wall Street analysts put a stock on their “buy” list because it’s selling
at the low end of its historical P/E range. They’ll also recommend a stock
when the price starts to drop, thereby lowering the P/E and making it seem
like an even bigger bargain.
In 1998, Gillette and Coca-Cola looked like great buys because they had
sold off several points and their P/Es looked more attractive. In actuality,
the earnings at both companies were showing a material deceleration that
justified a lower valuation. A great deal of P/E analysis is based on personal
opinions and theories that have been handed down through the years by
analysts, academicians, and others, whose track records when it comes to
making money in the market are both questionable and undocumented. In
2008, some Wall Street analysts recommended buying Bank of America all
the way down. There are no safe, sure things in the market. That’s why you
need avoid or sell rules as well as buy rules.
Reliance on P/E ratios often ignores more basic trends. The general mar-
ket, for example, may have topped, in which case all stocks are headed
lower. To say a company is undervalued because at one time it was selling at
22 times earnings and it can now be bought for 15 is ridiculous and some-
what naive.
One way I do sometimes use P/E ratios is to estimate the potential price
objective for a growth stock over the next 6 to 18 months based on its esti-
mated future earnings. I may take the earnings estimate for the next two
years and multiply it by the stock’s P/E ratio at the initial chart base buy
point, then multiply the result by 100% or slightly more. This is the degree
of P/E expansion possible on average if a growth stock has a major price
move. This tells me what a growth stock could potentially sell for during bull
market conditions. However, there are some bull markets and certain
growth stocks that may have little or no P/E expansion.
For example, if Charles Schwab’s stock breaks out of its first base at $43.75
per share (as it did in late 1998) and its P/E ratio at the beginning buy point
is 40, multiply 40 by 130% to see that the P/E ratio could possibly expand to
92 if the stock has a huge price move. Next, multiply the potential P/E ratio
of 92 by the consensus earnings estimate two years out of $1.45 per share.
This tells you what a possible price objective for your growth stock might be.
The Wrong Way to Analyze Companies in an Industry
Another faulty use of P/E ratios, by amateurs and professionals alike, is to
evaluate the stocks in an industry and conclude the one selling at the cheap-
est P/E is always undervalued and therefore the most attractive purchase.
The reality is, the lowest P/E usually belongs to the company with the most
ghastly earnings record.
The simple truth is that at any given time, stocks usually sell near their
current value. The stock that sells at 20 times earnings is at that level for one
set of reasons, and the stock that trades at 15 times earnings is at that level
for another set of reasons. A stock selling at, say, 7 times earnings does so
because its overall record is more deficient than that of a stock with a higher
P/E ratio. Also, keep in mind that cyclical stocks normally have lower P/Es,
and that, even in good periods, they do not show the P/E expansion that
occurs in growth stocks.
You can’t buy a Mercedes for the price of a Chevrolet, and you can’t buy
oceanfront property for the same price you’d pay for land a couple of miles
inland. Everything sells for about what it’s worth at the time based on the
law of supply and demand.
The increased value of great paintings was brought about almost single-
handedly many years ago by a fine-arts dealer named Joseph Duveen. He
would travel to Europe and buy one-of-a-kind paintings by Rembrandt and
others, paying more than the market price. He would then bring them back to
the United States and sell them to Henry Ford and other industrialists of that
era for substantially more than he had paid. In other words, Lord Duveen
bought the one-of-a-kind masterpieces high and sold them much higher.
The point is, anyone can buy a mediocre piece of art for a low price, but
the very best costs more. The very best stocks, like the very best art, usually
command a higher price.
If a company’s price and P/E ratio change in the near future, it’s because
conditions, events, psychology, and earnings have continued to improve or
started to deteriorate. Eventually, a stock’s P/E will reach a peak, but this
normally occurs when the general market averages are topping out and
starting a significant decline. It could also be a signal the company’s rate of
earnings growth is about to weaken.
It’s true high-P/E stocks will be more volatile, particularly if they’re in the
high-tech area. The price of a high-P/E stock can also temporarily get ahead
of itself, but the same can be said for lower-P/E stocks.
Insisting on three years of earnings growth will help you quickly weed out
80% of the stocks in any industry group. Growth rates for most stocks in
most groups are lackluster or nonexistent—unlike, for example,
• Xerox, which was growing at a 32% annual rate before its shares soared
700% from March 1963 to June 1966
• Wal-Mart Stores, which consistently created an annual growth rate of
43% before rocketing 11,200% from 1977 to 1990
• Cisco Systems, whose earnings were exploding at a 257% rate in October
1990, and Microsoft, which was growing at a 99% clip in October 1986,
before their enormous advances
• Priceline.com, which from 2004 to 2006 more than doubled its earnings
from 96 cents a share to $2.03, before it tripled in price in the next five
quarters
• Google, which had already expanded its earnings from 55 cents a share in
2002 to $2.51 a share in 2004 before its stock climbed from $200 to $700
by 2007
Keep in mind that an annual growth record doesn’t necessarily make a
company a solid growth stock. In fact, some so-called growth stocks report
substantially slower growth than they did in earlier market periods. Many
growth leaders in one cycle do not repeat in the next cycle.
The stock of a company that has an outstanding three-year growth record
of 30% but whose earnings growth has slowed to 10% or 15% in the last sev-
eral quarters acts like a fully mature growth stock. Older and larger organiza-
tions are usually characterized by slower growth, and many of them should be
avoided. America is continually led and driven by new innovative entrepre-
neurial companies. They, and not our government, create our new industries.
Insist on Both Annual and Current Quarterly Earnings Being Excellent
A standout stock needs both a sound growth record in recent years and a
strong current earnings record in the last several quarters. It’s the powerful
combination of these two critical factors, rather than one or the other, that
creates a super stock, or at least one that has a higher chance for true success.
The fastest way to find a company with strong and accelerating current
earnings and solid three-year growth is by checking the proprietary Earn-
ings per Share (EPS) Rating provided for every stock listed in Investor’s
Business Daily’s research stock tables.
The EPS Rating measures a company’s two most recent quarters of
earnings growth against the same quarters the year before and examines
its growth rate over the last three years. The results are then compared
with those of all other publicly traded companies and rated on a scale
from 1 to 99, with 99 being best. An EPS Rating of 99 means a company
has outperformed 99% of all other companies in terms of both annual and
recent quarterly earnings performance.
If the stock is newly issued and the company doesn’t have a three-year
earnings record, look for big earnings increases and even bigger sales
growth over the last five or six quarters. One or two quarters of profitability
are often not enough and indicate a less-proven stock that might fall apart
somewhere down the line.
Are Price/Earnings Ratios Really Important?
If you’re like most investors, you’ve probably learned the most important
thing you need to know about a stock is its P/E ratio. Well, prepare yourself
for a bubble-bursting surprise.
For years, analysts have used P/E ratios as their basic measurement tool in
deciding whether a stock is undervalued (has a low P/E) and should be bought,
or is overvalued (has a high P/E) and should be sold. But our ongoing analysis
of the most successful stocks from 1880 to the present shows that, contrary to
most investors’ beliefs, P/E ratios were not a relevant factor in price movement
and have very little to do with whether a stock should be bought or sold.
Much more crucial, we found, was the percentage increase in earnings
per share. To say that a security is “undervalued” because it’s selling at a low
P/E or because it’s in the low end of its historical P/E range can be nonsense.
Primary consideration should be given to whether the rate of change in earnings
is substantially increasing or decreasing.
From 1953 through 1985, the average P/E ratio for the best-performing
stocks at their early emerging stage was 20. (The average P/E of the Dow
Jones Industrials over the same period was 15.) As they advanced, the biggest
winners expanded their P/Es by 125%, to about 45. From 1990 to 1995, the
real leaders began with an average P/E of 36 and expanded into the 80s. But
these were just the averages. Beginning P/Es for most big winners ranged
from 25 to 50, and the P/E expansions varied from 60 to 115. In the market
euphoria of the late 1990s, these valuations increased to even greater levels.
Value buyers missed almost all of these tremendous investments.
Why You Missed Some Fabulous Stocks!
These findings strongly suggest that if you weren’t willing to buy growth
stocks at 25 to 50 times earnings, or even much more, you automatically
eliminated most of the best investments available! You missed Microsoft,
Cisco Systems, Home Depot, America Online, and many, many others dur-
ing their periods of greatest market performance.
Our studies suggest P/E ratios are an end effect of accelerating earnings
that, in turn, attract big institutional buyers, resulting in strong price per-
formance. P/Es are not a cause of excellent performance. High P/Es, for
example, were found to occur because of bull markets. Low P/Es, with the
exception of those on cyclical stocks, generally occurred because of bear
markets.
In a roaring bull market, don’t overlook a stock just because its P/E seems
too high. It could be the next great winner. And never buy a stock just
because the P/E ratio makes it look like a bargain. There are usually good
reasons why the P/E is low, and there’s no golden rule that prevents a stock
that sells at 8 or 10 times earnings from going even lower and selling at 4 or
5 times earnings.
Many years ago, when I first began to study the market, I bought
Northrop at 4 times earnings and watched in disbelief as the stock declined
to a P/E ratio of 2.
How Price/Earnings Ratios Are Misused
Many Wall Street analysts put a stock on their “buy” list because it’s selling
at the low end of its historical P/E range. They’ll also recommend a stock
when the price starts to drop, thereby lowering the P/E and making it seem
like an even bigger bargain.
In 1998, Gillette and Coca-Cola looked like great buys because they had
sold off several points and their P/Es looked more attractive. In actuality,
the earnings at both companies were showing a material deceleration that
justified a lower valuation. A great deal of P/E analysis is based on personal
opinions and theories that have been handed down through the years by
analysts, academicians, and others, whose track records when it comes to
making money in the market are both questionable and undocumented. In
2008, some Wall Street analysts recommended buying Bank of America all
the way down. There are no safe, sure things in the market. That’s why you
need avoid or sell rules as well as buy rules.
Reliance on P/E ratios often ignores more basic trends. The general mar-
ket, for example, may have topped, in which case all stocks are headed
lower. To say a company is undervalued because at one time it was selling at
22 times earnings and it can now be bought for 15 is ridiculous and some-
what naive.
One way I do sometimes use P/E ratios is to estimate the potential price
objective for a growth stock over the next 6 to 18 months based on its esti-
mated future earnings. I may take the earnings estimate for the next two
years and multiply it by the stock’s P/E ratio at the initial chart base buy
point, then multiply the result by 100% or slightly more. This is the degree
of P/E expansion possible on average if a growth stock has a major price
move. This tells me what a growth stock could potentially sell for during bull
market conditions. However, there are some bull markets and certain
growth stocks that may have little or no P/E expansion.
For example, if Charles Schwab’s stock breaks out of its first base at $43.75
per share (as it did in late 1998) and its P/E ratio at the beginning buy point
is 40, multiply 40 by 130% to see that the P/E ratio could possibly expand to
92 if the stock has a huge price move. Next, multiply the potential P/E ratio
of 92 by the consensus earnings estimate two years out of $1.45 per share.
This tells you what a possible price objective for your growth stock might be.
The Wrong Way to Analyze Companies in an Industry
Another faulty use of P/E ratios, by amateurs and professionals alike, is to
evaluate the stocks in an industry and conclude the one selling at the cheap-
est P/E is always undervalued and therefore the most attractive purchase.
The reality is, the lowest P/E usually belongs to the company with the most
ghastly earnings record.
The simple truth is that at any given time, stocks usually sell near their
current value. The stock that sells at 20 times earnings is at that level for one
set of reasons, and the stock that trades at 15 times earnings is at that level
for another set of reasons. A stock selling at, say, 7 times earnings does so
because its overall record is more deficient than that of a stock with a higher
P/E ratio. Also, keep in mind that cyclical stocks normally have lower P/Es,
and that, even in good periods, they do not show the P/E expansion that
occurs in growth stocks.
You can’t buy a Mercedes for the price of a Chevrolet, and you can’t buy
oceanfront property for the same price you’d pay for land a couple of miles
inland. Everything sells for about what it’s worth at the time based on the
law of supply and demand.
The increased value of great paintings was brought about almost single-
handedly many years ago by a fine-arts dealer named Joseph Duveen. He
would travel to Europe and buy one-of-a-kind paintings by Rembrandt and
others, paying more than the market price. He would then bring them back to
the United States and sell them to Henry Ford and other industrialists of that
era for substantially more than he had paid. In other words, Lord Duveen
bought the one-of-a-kind masterpieces high and sold them much higher.
The point is, anyone can buy a mediocre piece of art for a low price, but
the very best costs more. The very best stocks, like the very best art, usually
command a higher price.
If a company’s price and P/E ratio change in the near future, it’s because
conditions, events, psychology, and earnings have continued to improve or
started to deteriorate. Eventually, a stock’s P/E will reach a peak, but this
normally occurs when the general market averages are topping out and
starting a significant decline. It could also be a signal the company’s rate of
earnings growth is about to weaken.
It’s true high-P/E stocks will be more volatile, particularly if they’re in the
high-tech area. The price of a high-P/E stock can also temporarily get ahead
of itself, but the same can be said for lower-P/E stocks.
