Everyone loves cheap, especially investors. But when cheap becomes crap, cheap becomes expensive. In the stock market, investors are seduced by low-quality stocks looking cheap and promising at first sight. The moment of happiness lasts until they realize that the stock’s performance is moderate at best. And low-quality stocks often result in capital losses and dividend cuts.
A notorious dazzler
Dividing price by earnings is a common metric to determine a stock’s valuation. Unfortunately, “common” does not equal “correct.” In an open market, whenever something looks cheap, something is rotten. The stock market is one of the most open markets, thus cheap means something must be very rotten.
Don’t believe? Let’s have a look what “cheap” really means.
How cheap looks like
These charts show the relationship between earnings growth and price-earnings. As earnings decline, the stock price declines even faster, leading to a contraction of the price-earning-ratio. The stock becomes “cheap” because the company is in serious “earnings” trouble, and the market does not believe in fast recovery.
The stock price tumbled from above $70 in 2014 to less than $23 now. A painful capital loss for anybody invested. If you “took the chance” and bought in 2017 when the price-earnings-ratio was “only” 10, you still lost about 50 percent. Sole consolation: when all earnings are gone, there is no price-earnings-ratio anymore.
No price-earnings-ratio — then what?
Long-term investors should always invest in high-quality stocks, but the price-earnings-ratio has no clue about quality. That’s the problem, and that’s why we need other metrics. Which one, I’ll tell another time.
P.S.: The same goes for the price-to-book-ratio.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
The unemployment rate in DR Congo could skyrocket
The difficulties and bankruptcies generated by COVID-19 have had a devastating economic and social impact in Africa.On the private sector...
Alantra increased its income in the first quarter of the year
Alantra's net profit fell 13.5% during the first months of the year to $5 million (€4.5 million’). However, the company's...
Three Valencian startups selected for EIT Health’s Headstart program
EIT Health, selected 89 initiatives throughout Europe, to take part in the Headstart program. The companies will be able to...
The Corona crisis could bring momentum to the Swiss crowdfunding market
In 2019, almost $624.8 million (CHF 600 million) was brokered in Switzerland via crowdfunding platforms. That means the market continued...
Containment boosts electronic invoicing in Belgium
Forced to work at a distance, many companies have taken advantage of this period to make the leap to electronic...
Business7 days ago
The importance of empathy-based marketing
Crowdfunding3 days ago
The Municipality of Milan launches a call to co-finance civic crowdfunding campaigns
Crypto6 days ago
Is the Bitcoin course in a phase of consolidation?
Featured5 days ago
The economic woes on the stock markets could be long-lasting