Since carving out fresh highs in late October, world markets experienced the first significant correction in around five years, and for many it was a rude awakening. Billions of dollars worth of capital evaporated as investors panicked under the specter of a global credit crisis and a slowing US economy.
Although we are yet to return to record highs, markets have nonetheless seen a marked improvement. In the US, the Dow has jumped almost 10% since hitting its low for the year in early March, while in Australia the S&P ASX 200 has recovered more than 15%.
Despite the difficult conditions there are plenty of investors who have really capitalized on the recent gains, and they have done so by turning the recent drops to their advantage. Although share prices justifiably dropped on predictions for worsening economic conditions and falling corporate profits, there were many stocks that simply corrected too much – and it was those investors who were able to spot the bargains that have turned pain into gain.
The key to identifying value lies in the ability to objectively analyze key fundamental aspects of a business and weighing this against the implied value as determined by market action.
In doing this, analysts employ the use of some well established fundamental ratios which act to relate share price to an important metric of business performance. Perhaps the most common and well known of these ratios is the price to earnings ratio, or PE ratio. By comparing the relationship between a company’s share price and its earnings we are able to more effectively judge the value of a company.
In essence, the PE ratio measures the popularity of a stock. It tells us what kind of a premium the market is prepared to pay for an asset with a given earnings capacity. A stock with a high PE is one in which the market has a very favourable outlook – and as such is willing to pay a price that is well above the historic earnings. This is a perfectly reasonable thing to do provided earnings do in fact increase as expected. If however that does not turn out to be the case, the only thing left to correct is the share price, and it will certainly come tumbling down as soon as expectations change.
On the other side of the coin, we have stocks with a low PE. These trade with a very small premium to underlying earnings, and this can mean one of two things. Firstly, it could indicate that the market has a very poor outlook for company earnings. Alternatively, it could mean that the market has failed to correctly value the company in regard to its future earnings potential. While this may seem like a rare occurrence, it is in fact seen quite often, usually as a result of the market over reacting to bad news or suffering from a decline in sentiment over the sector or market as a whole.
Indeed, this is what acted to send many quality shares well below their fair value during the recent correction. Traders who identified these stocks were able to pick up quality investments at bargain basement prices.
So what do we mean by high and low, when talking about PE ratios? The ValueGain platform allows traders to take a relative approach, and compare PE with sector averages. This is often the most sensible approach because it identifies companies that are trading at attractive values relative to their peers.
Of course, manually comparing thousands of companies is a daunting task, so thankfully ValueGain will allow you to scan the market using the market scanner tool. You can create a simple scan that searches for stocks that have a PE less than the industry average. You can refine your selection by adding in other important criteria such as profitability (using return on equity) or even technical trade set-ups (such as Elliot wave 4 buy). Alternatively, you could take advantage of the built in pre-computed scans which have already been carefully calibrated to ensure you get some excellent results.
In either case, by measuring a share price relative to its earnings you can significantly enhance your ability to spot value, and as such multiply your chances for success.