Page 289 - How to Make Money in Stocks Trilogy

A = Annual Earnings Increases: Look for Big Growth 167

Our studies suggest P/E ratios are an end effect of accelerating earnings
that, in turn, attract big institutional buyers, resulting in strong price per-
formance. P/Es are not a cause of excellent performance. High P/Es, for
example, were found to occur because of bull markets. Low P/Es, with the
exception of those on cyclical stocks, generally occurred because of bear
markets.
In a roaring bull market, don’t overlook a stock just because its P/E seems
too high. It could be the next great winner. And never buy a stock just
because the P/E ratio makes it look like a bargain. There are usually good
reasons why the P/E is low, and there’s no golden rule that prevents a stock
that sells at 8 or 10 times earnings from going even lower and selling at 4 or
5 times earnings.
Many years ago, when I first began to study the market, I bought
Northrop at 4 times earnings and watched in disbelief as the stock declined
to a P/E ratio of 2.

How Price/Earnings Ratios Are Misused
Many Wall Street analysts put a stock on their “buy” list because it’s selling
at the low end of its historical P/E range. They’ll also recommend a stock
when the price starts to drop, thereby lowering the P/E and making it seem
like an even bigger bargain.
In 1998, Gillette and Coca-Cola looked like great buys because they had
sold off several points and their P/Es looked more attractive. In actuality,
the earnings at both companies were showing a material deceleration that
justified a lower valuation. A great deal of P/E analysis is based on personal
opinions and theories that have been handed down through the years by
analysts, academicians, and others, whose track records when it comes to
making money in the market are both questionable and undocumented. In
2008, some Wall Street analysts recommended buying Bank of America all
the way down. There are no safe, sure things in the market. That’s why you
need avoid or sell rules as well as buy rules.
Reliance on P/E ratios often ignores more basic trends. The general mar-
ket, for example, may have topped, in which case all stocks are headed
lower. To say a company is undervalued because at one time it was selling at
22 times earnings and it can now be bought for 15 is ridiculous and some-
what naive.
One way I do sometimes use P/E ratios is to estimate the potential price
objective for a growth stock over the next 6 to 18 months based on its esti-
mated future earnings. I may take the earnings estimate for the next two
years and multiply it by the stock’s P/E ratio at the initial chart base buy