To buy or not to buy, that is the question for many when we consider investing our hard-earned money in stocks. When it comes to investing in the stock market, Leo Fields’ maxim is that being on the conservative side “is being on the winning side.” That’s the best approach for a novice investor. What calculations should you use when deciding how much of your savings to invest in the risky business that is the stock market?
To find answers, you must first consider the current scenario, one in which Wall Street seems to set new records every day. Market strategists and financial pundits argue that stocks are still a great buy, which really means that stocks are fairly cheap. This is based on “forward earnings” projections, and one must be wary of these predictions.
Forward earnings, also known as the Price-Earnings Ratio (P/E), is one of the simplest and most common valuation metrics. Take the price per share and divide it by earnings per share, and you have your P/E. The lower the P/E, the less Wall Street values it. This gives the “forward” estimates for the next year.
But there’s a catch: future-earnings estimates are highly optimistic, mostly pointing to big increases in profits, which can be misleading. A “forward” price-to-earnings multiple is almost always far lower, and a lot more attractive, than the P/E based on results already on the books; in other words, the actual earnings recorded in the past. This is known as “trailing”.
Many investors use either forward earnings for the next year, or use trailing 12-month earnings, because they’re actual, tangible results. The secret lies in using both metrics to understand the true value of a stock.
We can also calculate the forward earnings or trailing using something called GAAP. The Generally Accepted Accounting Principles (GAAP) earnings for the Standard & Poor’s 500, developed by the Financial Accounting and Standards Board (FASB) to standardize financial reporting, provides a uniform set of rules and formats to facilitate analysis by investors and creditors. Finally, the CAPE (Cyclically Adjusted P/E) ratio, developed by Yale economist Robert Shiller (it’s also known as the Shiller P/E ratio), is another good way to judge of the value of a stock.
This brings us to the real questions you need to ask before you invest, such as how do today’s forward estimates of the stocks compare with past projections? And is the forward P/E low or high by historical standards?
The essential point is, if you’re looking to determine whether stocks are expensive or cheap, rely on the likes of trailing, GAAP numbers, or the CAPE/Shiller P/E ratio. Following forward multiples will fool you. Good luck investing!
Latha Ram | Contributing Writer