Monkeys are great stock pickers. Had your garden-variety primate randomly selected five stocks in March 2009, chances are it would now be sitting on huge capital gains, contemplating reinvesting them in bananas by the truckload.
It's easy to see that our monkey, who now sees itself as a future fund manager, is mistaking luck for skill. What's harder to see is that we might be making the same mistake.
If examining your portfolio's returns over the past few years engenders a feeling of self-satisfaction, you're running that risk. With valuations increasing for many stocks over the past year, now is the time to educate yourself. Consider the following a lesson in fire safety. Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. So, too, is valuing assets: discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly used tool, hammered into every finance and business student.
But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.
Other tools are available to help you avoid this error. The price-earnings (P/E) ratio is a regularly used proxy for stock valuation, but also one of the most over-used and abused metrics. To make use of it, you need to know when and when not to use it.
The P/E ratio compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first. In the past financial year, XYZ Ltd made $8 million in net profit (or earnings). The company has 1 million shares outstanding, so it achieved an EPS of $8 ($8 million profit divided by 1 million shares). In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.
At the current share price of $100, the stock is therefore trading on a historic P/E ratio of 12.5 ($100/$8). Using the forecast for current year's earnings, the forward or "forecast P/E ratio" is 10 ($100/$10).
The key point is that a P/E ratio is a reflection not of what you earn from a stock, but "what investors as a group are prepared to pay for the earnings of a company". All things being equal, the lower the P/E ratio the better. But there is a list of caveats.
Quality usually comes with a price to match. It costs more, for example, to buy hand-crafted leather goods from France than a cheap substitute from China. Stocks are no different: high-quality businesses generally, and rightfully, trade on higher P/E ratios than poorer-quality businesses.
Value investors love a bargain. But while a low P/E ratio for a quality business can indicate value, it doesn't alone guarantee it. Because P/E ratios are only a shortcut for valuation, further research is mandatory. Likewise, a high P/E ratio doesn't ensure that a stock is expensive. A company with strong future earnings growth may justify a high P/E ratio, and may even be a bargain. A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high P/E ratio. But for a poor-quality business with few prospects for growth, a high P/E ratio is likely undeserved.
P/E ratios are often calculated using reported profit. Especially in newspapers or on financial websites. But one-off events often distort headline profit numbers and thus the P/E ratio. Using underlying, or "normalised", earnings in P/E ratio calculations is likely to give a truer picture.
What is a normal level of earnings? If you don't know how to calculate these figures for your stocks, establish whether skill or luck is driving your returns. If you don't know, history may make a monkey of you.
This article contains general investment advice only (under AFSL 282288).
The numbers you need
... is the highest price per troy ounce ever reached by gold, in September 2011. Late last week, the price fell below $US1300. Having fallen by more than 20 per cent since its acme, gold is officially in a bear market. The lurches in gold have grabbed the headlines but some experts say falling oil prices are of much greater economic significance. Brent crude is down about 16 per cent from the year's high, hit in February.
... is the median super balance of women aged 35 to 44. For men of the same age the balance is almost twice that. For those about to retire - 55- to 64-year-olds - men have a median balance of $91,000 compared with $55,000 for women. Writing in Sunday Money, Mark Bouris said women felt excluded from super and a system that forces them to "turn away or turn off completely". To read Bouris' column go to theage.com.au/money
... is the amount of cheese British firm Dairy Crest has given its pension fund. The company has granted a floating charge over the cheese to its pension fund trustees. It means that in the unlikely event the firm goes bust, the trustees will become owners of £60 million ($89 million) of cheese and can sell it. This strengthens the pension fund while giving Dairy Crest the chance to keep and spend cash in the business.