Investing Basics. Basic Investment Indicators - Part 1

More and more people are following stock market events with interest and trying their hand at the market. Unfortunately, the lack of appropriate knowledge can lead to quick and large losses.

Every stock exchange has had its better and worse moments which are connected with greater or lesser interest from investors. The last large wave of increased interest in stock exchanges in Europe came after the panic sell-off of shares in March 2020 (the outbreak of the COVID-19 pandemic). However, it quickly turned out that the market had overestimated the impact of the pandemic on the results of companies, as many of them benefited from changings, specifically, ?they have expanded their areas of activity or created new areas of activity, such as the supply of medical equipment or the creation and provision of programs and systems for remote work.

The years 2020 and 2021 passed with growth driven by low interest rates and numerous aid programs that were supposed to support the economies by governments. This gave investors the false impression that you do not need to have knowledge about the functioning of the market and investments to achieve high rates of return on the stock exchange. Unfortunately, this leads to overconfidence, excessive risk-taking and, as a result, losses that can lead to life's dramas.

It is better to lose an opportunity than money

During a bull market, it is easier to make profits, but it is never too late to start investing and it is not worth rushing into it. We do not start replacing the electrical installation in our home after reading advice on a thematic forum or reading the book Electrical Installations for Beginners. It is similar with the stock exchange. In discussion groups, you can come across advice that it is best to learn from mistakes and it is worth buying some shares right away, even for a small amount. This is an ideal way to quickly lose money that could be spent on buying books or courses, to improve your knowledge. I would like to point out that you should be especially careful. During every bull market, self-proclaimed experts appear who convince on blogs, YouTube, or closed forums that they are able to teach anyone to invest, that it is not difficult and there is no point in waiting.

Investing is not easy

If someone claims to have found a way to make money on the stock market and offers some guarantees, it means that only their profit from selling training is guaranteed. Even capital market legendary gurus made mistakes and it usually cost them a lot...

To invest rationally, you must first learn at least the basic mechanisms of market operation, sources of information, rights and obligations of shareholders, methods of analysing charts, data and information, as well as psychological aspects. Learning the basics does not take that much time, but it allows you to assess whether investing is an activity for you at all and not be fooled by the expensive services of pseudo-experts. The most popular mistake of novice investors is simplifications such as using indicators without understanding them. Let's take the popular Price/Earnings indicator as an example.

The Price/Earnings Ratio (or just P/E) is undoubtedly one of the most popular indicators used by investors around the world. This parameter is often used to value companies using comparative methods. Contrary to appearances, the P/E ratio is not easy to interpret and often likes to play tricks.

To clearly understand what is the charm of the P/E let's go deeper into its details.

Let's start with the question of how much the owner will be willing to sell a company that earns an average of USD 1 million per year for? According to the book theory, for a dozen times more.

The P/E ratio measures a company’s current share price relative to its earnings per share (EPS), consequently, P/E tells us in what period (counted in years) the company is able to repay its capitalization. In other words, this indicator shows how many years the investor has to wait until the funds he spent on buying the shares are returned, assuming a 100% dividend payment and the stability of profit over time.

We can illustrate the explained theory with an example. So with an annual profit of USD 15 million and the Price/Earnings indicator of 15, the investment will return to the buyer after 15 years.

At first glance, it might seem that investors should look for companies listed with the lowest P/E ratio. A company that is listed at a P/E of 5 should be much more attractive than its competitor, which has a ratio of 15. In the first example, the company will generate as much profit over 5 years as its current capitalization at the moment of the investment. Assuming that the dividend will be paid out at 100% of net profit, this means that the investor will be able to receive a return on the invested money in 5 years. In the second case, it would take 3 times longer. Is such a simple interpretation justified? Or maybe this is the famous Holy Grail?

Unfortunately, the answer is not affirmative. If such a principle worked, it would be possible to create an automatic system that selects 10 companies with the lowest P/E ratio once a quarter or a month and go on a long vacation lasting several years.

Below I present just a few basic traps resulting from mechanical reading in indicator:

? When a company has been generating losses in the last 12 months, the P/E ratio will be negative. Of course, in such a case it does not mean anything good so the approach “ a lower ratio is necessarily better” is wrong.

? Profits (i.e. the denominator) may be distorted by one-off events that were reported in a given period. I will dedicate a separate paragraph to discussing this issue, considering its importance.

? Investors may simply not believe in the quality of reported profits. There may be many reasons for such a lack of faith. From the lack of coverage of such profits by operating cash flows (so-called paper profits) and the fact that the company, despite excellent results, does not pay dividends. Through suspicions that profits primarily come from an increase in the valuation of assets (e.g. shares of unlisted companies or the value of real estate) and it is not certain whether they will ever be converted into real cash.

? Companies with the lowest but positive P/E ratios are often in trouble, close to bankruptcy, or are undergoing restructuring. This is mainly due to the fact that investors see the risk of bankruptcy, so share prices go down faster than the profits of such companies. Such behaviour obviously affects the decrease in the P/E ratio.

? Reported profits, and therefore also the P/E ratio, refer to the past. Considering the reporting period (the permissible period is as long as 2 or 3 months after the end of the quarter), they may no longer reflect what will happen in the future. We know well that on the stock exchange we value and buy the future, so current (or rather past) profits cannot tell us much about the results the company will achieve in the following quarters. Some analysts and investors try to minimize this risk by calculating the P/E ratio based on the expected profits.

? When the right to a dividend is established, the price is automatically adjusted by the value of the dividend. If the dividend yield is quite high, this will result in a sudden decrease in this indicator.

And last but not least at all: The market price is always the result of supply and demand meeting. What means that all calculations and theories might be completely useless, if this “magic” hand of the market would decide differently…

I have previously indicated only a few factors that may determine the valuation, but investors must answer the questions every day - buy? sell?

The price may also be underestimated, because the shares are sold by significant shareholders, e.g. investment or pension funds, which must sell the shares to return the money to investors or the state. These may also be founders and management staff. After all, each of them has their own life and may at some point in the company's development want to sell some of the shares they hold to use them for private purposes. Or maybe they know that the company's prospects are not as good as investors claim and are taking advantage of the opportunity to get rid of the shares at an attractive price? Fortunately, the law obliges companies and people sitting on their bodies to inform all investors about important events that may affect the valuation.

Summary

Now that we have presented and discussed the traps that await investors using the P/E indicator, it is time for a few tips. Of course, the following points do not guarantee success. In my opinion, however, they are worth considering, because they should allow you to eliminate at least some of the companies from your portfolio that look attractive at first glance, but in reality may not be. This in itself may already be valuable, because eliminating some of the losing transactions can increase our effectiveness, which, with an unchanged profit-to-risk ratio, should result in better investment results.

? If you want to invest in the stock market based on the P/E ratio, prepare for long searches and analyses. Taking shortcuts will usually not guarantee success, because most of the information and reported data are already included in the share price.

? Make sure of the quality of the data reported by a given information portal and check whether the profits are not distorted by one-off events (positive or negative).

? Remember that the P/E ratio is based on historical profits. Estimate how they will change in the future and how this may affect the index valuation. In such a case, you need to assess whether the current value of recurring profits can be used to forecast the future. Future earnings dynamics may be significantly different from those in the past.

? Assess the possibility of a significant share issue in the near future that will affect the company's capitalization, which may cause a deterioration of the P/E ratio.

? Beware of companies that are rapidly increasing sales and are expensive in terms of P/E. Their valuation often heavily discounts the future. If the pace of development slows, the price reaction may be much stronger.

? A company that has reported very good results does not necessarily have to grow. These results may already be in the current price and high valuation according to P/E. Assess critically whether the company is able to improve results in subsequent quarters (y/y), which should result in a decrease in the P/E ratio (or an increase in price).

? When analysing a company, always check the P/E ratio not only for the competition and the sector, but also at what levels the company was trading in the last few years. Such historical levels may, but do not have to, be an indication of whether the company is valued cheaply or expensively.

? Remember the relative valuation trap. If the stock market is at its peak, then P/E valuations are usually high. At such a moment, comparing the company's valuations to the stock market average is subject to significant risk. The P/E ratio at a time of a stock market downturn may simply fall to average levels or lower, which will result in your probable loss.

? In each case, when the value of the indicator is suspiciously low or high in absolute terms and/or compared to the sector or direct competitor, you need to understand the reasons why this is happening.

? Consider the following investment strategy. Look for companies with a low projected P/E ratio relative to the actual prospects of such a company. If you estimate that a company at its current price will have a 5 P/E ratio in a year, with an average ratio in the sector at 10, and an average on the stock exchange around 12, this can often be an interesting investment opportunity.

? However, remember the basic rules of the stock exchange. First, if shares are cheap, they can be even cheaper, and expensive shares can continue to rise in price. Second, markets can be inefficient for longer than an investor can bear.

The purpose of this article is neither to define all the variables that affect P/E, nor to find interdependencies and correlations between them. Rather, it is an attempt to show that blind reliance on a simple relationship such as low P/E - chance of profit and high P/E - risk of loss is too simple and does not necessarily lead to investment success. ?

Author

Grzegorz Kucharski , Chief Strategy Officer,? Management Board Member of Armenia?Securities Exchange

Contributor?

Viktorya Shakhmaryan,?Legal Counsel of?Armenia Securities Exchange