Mike's 10 Must Follow Rules for Making Consistent Profits in the Stock Market
Rule #2: Avoid Expensive Stocks
Unfortunately, many investors look at the price of a stock and draw a conclusion about whether or not it is an expensive stock. Common sense seems to dictate that more a stock costs per share, the more expensive it is. Nothing could (potentially) be further from the truth. It is entirely possible that the $5 stock is many times more expensive than the $400 stock. Here's why...:
One of the very best ways to determine whether one stock is more expensive than another stock is to compare the two stocks' PE ratio. The PE ratio (Price Earnings Ratio) is the ratio of a company's current share price compared to its per-share earnings.
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the PE ratio for the stock would be 22.05 ($43/$1.95).
The PE is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (PE) of 20, an investor would be paying $20 for $1 of earnings.
But... the key here is HOW you use one stock's multiple or PE ratio in comparison to another. PE ratios are not absolute. They are, rather, only slightly relative to the average PE ratio of the entire S&P-500. They are very relative when comparing the multiple of one stock to another in the same industry.
It does little good to compare the PE ratio of an Internet Service Provider company to the PE ratio of a Healthcare Provider company.
When I am trying to select a stock based on its fundamentals, I first DO NOT consider the stock's PE ratio. I only begin to look at the PE ratio when I am narrowing down my selection between two stocks of the same industry. Then, and only then, do I consider the stock's PE.
My rule is: When all other fundamentals are equal between two stocks of the same industry, the one with the lower PE can be considered less expensive than the one with the higher PE.
My goal is to not buy stocks with PE's in the upper 20% of their peer group of maximum range of PE. This is NOT a hard and fast rule, but more of a rule to follow when two stocks are equal in every other way, and you need to select only one. In that case, I'd select the stock with the lower PE ratio.
I do have a corollary to this rule... Also avoid "cheap stocks".
Cheap does NOT equal inexpensive. I consider penny stocks and most stocks under $5 as too cheap to consider in my portfolios.
Continue to Rule #3, Trade Like a Technician. |
