Excerpt from Trade Like a Stock Market Wizard, by Mark Minervini.
When you think of value in the traditional sense, bargains immediately spring to mind: something once priced higher now is priced lower. It seems logical. Growth stock investing, however, can turn this definition on its head. In the stock market, what appears cheap could actually be expensive and what looks expensive or too high may turn out to be the next superperformance stock. The simple reality is that value comes at a price.
The P/E Ratio: Overused and Misunderstood
Every day, armies of analysts and Wall Street pros churn out thousands of opinions about stock values. This stock is overvalued; that one is a bargain. What is the basis of many of these valuation calls? Often its the price/earnings ratio (P/E), a stocks price expressed as a multiple of the companys earnings. A great amount of incorrect information has been written about the P/E ratio. Many investors rely too heavily on this popular formula because of a misunderstanding or a lack of knowledge. Although it may come as a surprise to you, historical analyses of superperformance stocks suggest that by themselves P/E ratios rank among of the most useless statistics on Wall Street.
The standard P/E ratio reflects historical results and does not take into account the most important element for stock price appreciation: the future. Sure, its possible to use earnings estimates to calculate a forward-looking P/E ratio, but if you do, youre relying on estimates that are opinions and often turn out to be wrong. If a company reports disappointing earnings that fail to meet or beat the estimates, analysts will revise their earnings projections downward. As a result, the forward-looking denominatorthe E in P/Ewill shrink, and assuming the P remains constant, the ratio will rise. This is why its important to concentrate on companies that are reporting strong earnings, which then trigger upward revisions in earnings estimates. Strong earnings growth will make a stock a better value.
MARK MINERVINI, one of America’s most successful stock traders, has been a veteran of Wall Street for nearly 30 years. He founded Minervini Private Access, an online members-only platform that provides real-time access to his SEPA stock trades. He also conducts a live Master Trader Program where attendees experience hands-on education about his methodology.
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