How to beat the leaders in the quarterly competition?

The slightly positive trend of the market last week assisted HKN, FortuneTeller and Fred, to keep leading the quarterly competition. The gap between the leaders and the players ranked fourth and below is not small, but intelligent investors can still catch up with them in the three weeks left in the quarter. Remember that this is a virtual competition and that your real savings are not in danger. So, trade!

Don’t say to yourself “the gap is too large”. Many Yalicoo investors have shown in the past that it is possible to gain more than 10% in one week; there are three weeks left until the end of the quarter and by choosing the right stocks you can still catch up to the leaders and even beat them. So, keep trading more stocks. Benefit from the positive trend of the market and try choosing stocks that you think will rise even more sharply in the weeks to come. I don’t have the names of these stocks for you, but you can surely find them by digging into the portfolios of other players in the various competitions. Stocks are very volatile – remember that and benefit from that. And did I mention already that you should trade more on Yalicoo?

Yalicoo is an educational stock trading simulator. This means that it is not only a trading simulation tool; it also has educational purposes that can assist you in becoming a better investor in real life. Investing is not a rocket science, but in order to become a better investor it is recommended that you learn as much as you can about the stock market and about investment strategies. Every week we will try to present you with educational we believe is required. Some of the things we will say here won’t be a big surprise to many of you, but remember that great investors always try to improve by extensive reading and learning. This week, let’s discuss the many drawbacks of the well known Price to Earning (P/E) ratio.

The Earning Per Share by itself does not mean much. To look at a company's earnings relative to the price of its shares, most investors employ the Price to Earnings (P/E) ratio. The P/E ratio, often called “multiple”, divides the stock price by the last four quarters' worth of earnings (this is the same as dividing the market capitalization of the company by its total earnings). For instance, if ABC Corp. is currently trading at $15 a share and its last four quarters earning per share is $1, it would have a P/E of 15.

The P/E is used by many investors to trace bargain stocks. The underline assumption is that companies that run similar businesses (i.e. are from the same industry) should have similar P/E. Therefore, low P/E stocks are often considered to be a bargain. Is it really true? Not always.

While some P/E stocks could be cheap, many of them are not such attractive investments. For example, consider a company with a low P/E which has a large debt. In this case, the market cap of the company does not truly reflect its real value (its Enterprise Value – EV, which equals the market cap plus the debt minus the cash owned by the company). The real EV of the company would be the sum of its market cap and its debt, making the numerator larger, thus the P/E will be larger than what it was initially calculated to be. In simple words, it means that the real price of the stock is not as cheap as it seems to be.

On the other hand, if a company has a higher P/E ratio, it doesn’t necessarily mean it is not cheap. If this company is loaded with a lot of cash, then again its market cap wouldn’t reflect its true value; in this case the EV of the company would be its market cap minus its cash, thus dramatically lowering the P/E value. In order to avoid this problematic feature of the P/E, it is wise to use a different ratio, called the Earning Yield, which is calculated by dividing the earnings of the company by its EV.

Another problematic feature of the P/E is its dependence on past performance of the company. The earnings of the past 12 month are not necessarily an accurate prediction of future earnings. A company could have a uniquely profitable year for many reasons but its future earnings could be ambiguous. Therefore, only looking at the trailing P/E is kind of like driving while looking out the rearview mirror- it is important but the obstacles you should be careful of lie ahead of you. In other words, many stocks which are traded with low P/E these days, often deserve to have a low P/E because of their questionable future prospects.

One of the not so commonly used ratios, which can solve this issue, is the Price to Earning Growth (PEG) ratio. The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable, the PEG ratio makes a lot of sense.

But this is not the end of the story, since the PEG also has a crucial problematic feature – it depends on the assumed growth of the company, a parameter which is obviously unknown by itself. In any case, considering a low P/E ratio as an initial screening criterion for finding bargain stocks could be useful. But, this by itself does not assure a cheap stock, and additional criteria must be considered in order to find a true bargain.

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