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.
Soybean, cotton markets hope for US-China trade resolution
The United States and China are expected to conduct more meetings this week. Markets wait for both countries to reach...
How to turbocharge your productivity in only 4 minutes a day
This four-minute exercise will make you more efficient and organized so you can stay on top of the day’s tasks.
4 steps to optimize your website for voice search
Is your business ready to utilize voice search to reach more people?
Rent to live, buy to rent: A real estate strategy to live by
Use your equity and cash flow from owned rentals to buy the far cheaper foreclosures then rent them out for...
Here’s why the Sanders-Schumer bill limiting stock buybacks misses the point
Senators Bernie Sanders and Chuck Schumer have proposed a new law where public companies have to meet certain conditions first...
- Entrepreneurship2 days ago
5 marketing trends small businesses will see in 2019
- Featured3 days ago
4 reasons why even the most experienced executives need advisors
- Economy4 days ago
Why port funding is now in the critical category
- Featured2 days ago
5 forex trading tips to help you find success in the market