Page 290 - How to Make Money in Stocks Trilogy

168 A WINNING SYSTEM

point, then multiply the result by 100% or slightly more. This is the degree
of P/E expansion possible on average if a growth stock has a major price
move. This tells me what a growth stock could potentially sell for during bull
market conditions. However, there are some bull markets and certain
growth stocks that may have little or no P/E expansion.
For example, if Charles Schwab’s stock breaks out of its first base at $43.75
per share (as it did in late 1998) and its P/E ratio at the beginning buy point
is 40, multiply 40 by 130% to see that the P/E ratio could possibly expand to
92 if the stock has a huge price move. Next, multiply the potential P/E ratio
of 92 by the consensus earnings estimate two years out of $1.45 per share.
This tells you what a possible price objective for your growth stock might be.

The Wrong Way to Analyze Companies in an Industry

Another faulty use of P/E ratios, by amateurs and professionals alike, is to
evaluate the stocks in an industry and conclude the one selling at the cheap-
est P/E is always undervalued and therefore the most attractive purchase.
The reality is, the lowest P/E usually belongs to the company with the most
ghastly earnings record.
The simple truth is that at any given time, stocks usually sell near their
current value. The stock that sells at 20 times earnings is at that level for one
set of reasons, and the stock that trades at 15 times earnings is at that level
for another set of reasons. A stock selling at, say, 7 times earnings does so
because its overall record is more deficient than that of a stock with a higher
P/E ratio. Also, keep in mind that cyclical stocks normally have lower P/Es,
and that, even in good periods, they do not show the P/E expansion that
occurs in growth stocks.
You can’t buy a Mercedes for the price of a Chevrolet, and you can’t buy
oceanfront property for the same price you’d pay for land a couple of miles
inland. Everything sells for about what it’s worth at the time based on the
law of supply and demand.
The increased value of great paintings was brought about almost single-
handedly many years ago by a fine-arts dealer named Joseph Duveen. He
would travel to Europe and buy one-of-a-kind paintings by Rembrandt and
others, paying more than the market price. He would then bring them back to
the United States and sell them to Henry Ford and other industrialists of that
era for substantially more than he had paid. In other words, Lord Duveen
bought the one-of-a-kind masterpieces high and sold them much higher.
The point is, anyone can buy a mediocre piece of art for a low price, but
the very best costs more. The very best stocks, like the very best art, usually
command a higher price.