A Bargain Doesn’t Always Come at a Low Price
For beginner investors, it’s important to distinguish between high-priced stocks and expensive stocks.
It’s about more than just semantics. It could be the difference between finding a bargain and overpaying.
A high stock price doesn’t necessarily translate into “too expensive.” To properly value a stock, it’s important to look beyond the market price.
On its own, a stock price is just a number. To see how cheap or expensive a stock is, you must analyze the company. You must look at underlying financial metrics.
These all seem like obvious points, but even experienced investors sometimes forget the essentials. As 2020 gets underway, let’s review a few basics of value investing, to start the new year on the right foot.
Evaluation by EPS
One common metric that analysts and investors look at is the price-to-earnings (P/E) ratio. This metric is calculated by dividing the stock’s earnings per share (EPS) by the stock price. Basically, it shows how much you are paying for $1 of earnings.
Let’s consider Northrop Grumman (NYSE: NOC), one of the largest defense companies in the world.
The stock trades for about $345. A beginner investor might dismiss the stock based on the price alone because he thinks it is too “expensive.” But that would be a wrong way to evaluate the stock.
Instead, let’s see how much profit the company makes.
The company has earned $19.42 per share over the past four quarters, which means its trailing P/E is 17.7.
Favorable Comparison to Index
To compare, the trailing P/E of the S&P 500—widely regarded as a proxy for the stock market—is 24. Thus, even though Northrop is high priced, relative to the overall market it really isn’t expensive.
Let’s take a look at P/E from another angle. Since the market is forward looking, it’s more helpful to look at how NOC’s forward P/E stacks up against that of the S&P.
According to FactSet estimates, Northrop will earn $21.92 over the next four quarters. That puts the forward P/E at 15.7.
How about the S&P 500? Its forward P/E is about 18.
Thus, on a P/E basis, NOC is actually inexpensive, despite the high price tag.
Taking Growth Into Account
Some of you may be thinking at this point, what about earnings growth?
That’s a great question.
To take projected growth into account, there’s something called the PEG (P/E-to-growth) ratio. It’s calculated by dividing the P/E ratio by the expected earnings growth rate. It tells you how much you are paying for 1% of growth. The lower the ratio, the less you are paying for growth.
According to FactSet, Northrop’s projected long-term (three-to-five years) annual growth rate is 9.7%. That means its forward PEG ratio is 1.6 (15.7 ÷ 9.7).
For the S&P 500, its projected long-term annual growth rate is 10.2%. That means its PEG is 1.7.
Northrop is cheaper in terms of PEG, too.
Projections Are Just Projections
Of course, when we talk about projections, everything is an educated estimate. Events could turn out very differently than expected. An unexpected event is usually what makes a stock make a big move up or down.
However, it is fair to say that despite a price well above $300 a share, Northrop is actually an inexpensive stock.
By the same reasoning, a $10 stock with a forward PEG of 5 is not cheap. Quite the opposite. It is low priced, but it is expensive.
Earnings is a useful way to compare different companies, particularly mature ones. But sometimes earnings is an imperfect evaluation tool for fledgling companies, especially in new industries. New companies typically seek to expand market share by heavily investing in growth, so they haven’t become profitable yet.
For example, thanks to the legalization of marijuana in more and more U.S. states, the market for legal marijuana has boomed in recent years.
The accelerating trend toward looser marijuana laws suggests that more states will join the party in 2020 and the addressable market will become even bigger. However, most cannabis-related companies are small-caps and unprofitable.
In these cases, for the time being, metrics like revenue growth and market share are more important than profits. Just because a marijuana-related company isn’t making money yet doesn’t necessarily mean it’s not a good investment and vice versa.
Indeed, there is no one-size-fits all approach to analyze every stock. However, one constant stays true no matter what company you look at. To do a proper analysis, you need to understand what is important to that company and industry.
Our investment team recently applied these tried-and-true valuation metrics to the fast-growing but volatile marijuana industry. For our new report on the best values in the thriving cannabis sector, click here now.