Margin of safety is very important. It seems to be like that the human psychology is apt to go too far sometimes and it can all end up to throw rational valuation out of the window.
You know that price-to-earnings for Facebook is 12, and 13 for Twitter, and if you are paying more than 15 times the earnings for a company, you need to seriously examine the underlying assumptions you have for the companies profit in the future, and its intrinsic value.
I have seen many stocks trading with much more than 12 and 13x earnings, and if you have bought some of them at that price you would have crushed other investments because the underlying prifits did live up to Wall Streets expectations.
But who is investing in a risky business if they don`t know the business they are in? Do you feel confortable if you have all your money in a risky stock like that if you don`t know the demand, competitors, future drivers and the commodity nature of their product? The company can be wiped out, so does your money, but probably not.
The ideal situation is when you get a great business out of your investments and generates huge amount of money with little capital investments. Sometimes you get a huge profit at a steep discount to intrinsic value. How about Wells Fargo, trading at 5x earnings during the real estate crash 23 year ago?
You have to predict the future and try to imagine how the future will be for the company. How is it today, tomorrow, next year and how does it look in 10 years? Is this business going to grow? Will it be a huge demand for their products? Are they competetive? What about their earnings and profit in the future? Is there any threats?
I know a great company. They are selling cd`s and vinyl records. Everybody knows about the company and the price is low. Are you willing to buy shares in this company? Of course not. Selling vinyl and cd`s is not the future and you know that. The future is streaming and broadband. That is where you are going to spend your money.
It is wise to require a much larger margin of safety before you buy some shares in enterprises. The right definition of ‘Price-Earnings Ratio – P/E Ratio is; A valuation ratio of a company’s current share price compared to its per-share earnings. It is calculated like this:
Let`s say company A is currently trading at $50 a share and earnings (EPS) over the last 12 months were $1,95 per share. Then the P/E ratio for the stock should be 25,6. ($50/$1,95). That`s it. Remember that the average market P/E ratio is 20 – 25 times earnings.
EPS (earnings per share) is taken from the last four quarters (trailing P/E). Sometimes the numbers is taken from the estimates for the next four quarters (projected or forward P/E). Other use the last two actual quarters and the estimates of the next two quarters. Often known as “price multiple” or “earnings multiple”.
It will be wrong to compare price-to-earnings in a technology company (high P/E) to a utility company (usually low P/E) as they have a different growth prospects. P/E tells us how much investors are willing to pay per dollar of earnings. P/E for Facebook is 12, which means that the investors is willing to pay $12 for $1 of current earnings.
Avoid basing a decision on this measure alone, because this numbers is usually not enough. the earnings is based on an accounting measure of earnings that is susceptible to forms of manipulation. It makes the quality of the P/E only as good as the quality of the underlying earnings number. Keep in mind that companies that are losing money do not have a P/E ratio.
News today: Trade Balance & Unemployment Claims at 8:30am, Fed Chairperson Yellen Testifies at 10:00am, 30 Year Auction at 1:01pm.
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