|Price = Earnings X Avg. P/E Ratio|
I love how analysts will go to incredible lengths in trying to figure out what the stock of a company should be worth. They use mathematical models that would give a genius pause. These models are usually the product of decades of research into market behaviour. Most are proprietary - they wouldn't want anyone else to steal their secrets gleaned from day to day experiences in the markets. How could we, for even a second, believe that we could ever hope to understand prices when it has taken them a lifetime? Why even try? Until, that is, we read the line that says, "Past results cannot be used to predict future performance." Huh?!?
The truth is, nobody has ever developed a model that works in every type of market every time. In fact, nobody has ever developed a model that works in most markets most of the time. I believe the reason these models are so complicated is because every time something goes wrong with the model, it has to be updated and amended so that, next time, they won't make the same mistake. Still, there is no forecasting the markets.
Having said that, we need to understand that trends develop in the markets. After all, markets are the product of human interaction, and we know how people can develop a herd mentality. What that means is while prices may be affected by people's perceptions of different events as they occur, prices tend to follow a trend for periods of time. This is huge when it comes to technical analysis, but it can also be used in fundamental analysis.
I have blogged earlier about Price/Earnings ratios http://ianbrennan.blogspot.com/2011/03/price-earnings-ratio.html as a means of calculating a fair price for any stock I might want to own. Studying the trend in RIM's Price/Earnings ratio over the past number of years, I feel comfortable using a value of 10. If anything, 10 would appear to be low, given the growth rate of the company in recent years. By using a value of 10 I am saying that I am willing to pay 10 times annual earnings for a share in RIM. For a company growing at the rate that RIM has, and is, most people would normally be prepared to pay much more. Using the guideline of never paying more than twice the growth rate of the company, that would suggest RIM is only going to grow somewhere between 5 and 10 percent next year. Given the company's past performance, this is clearly a conservative estimate.
Annual mean earnings for the fiscal year ending February 2012 are estimated to be $6.91. Earnings of $6.91 times an estimated Price/Earnings of 10, gives us a price of $69.10. Given the current price as at the end of April 28, of $53.83, that would give us a potential up side of $69.10 - $53.83 / $53.83 = 28 percent!
Can it really be that easy? What about management, products, cash flow, and all that stuff? Think of it in this way. Let's say we want to buy a new car that is reliable and has better than average gas mileage? Should we pay more than a similar car that is not reliable? Should we pay more than a similar car with poor gas mileage? Should we pay more for a car that is popular - one which people are happy to own? While there are other considerations (whether, or not, the company is going broke), we can see in this case that we are looking at a company which can offer a better car, hopefully at a fair price. What we need to know about the company is baked into it's history of being able to offer a better vehicle at a better price - one which people enjoy owning (assuming that is the case).
Would the company continue it's favourable history if it was poorly managed? Would that likely be the case if they had poor quality control? Would that likely be the case if the company was not offering value to it's customers? I'm from the school that says if it quacks like a duck, it looks like a duck, and it acts like a duck, then it is probably a duck!
How fast the company is growing is reflected in the earnings estimates and the historical Price/Earnings ratio. The same for management, and competition, and financing, and inventory, and on, and on. What that also means is I only buy reliable companies (one's with a consistent history of earnings - which also means they are making money). Still, I don't just blindly follow earnings estimates. They will be too high going into a market correction. I watch for earnings revisions on any company I own, or want to own, and know that analysts don't usually anticipate future market corrections.
So, with a potential, conservatively estimated gain of 28 percent, then RIM is a buy, right? Well, not so fast. Next time we look at the trend in RIM's price before I put in my order.
Can you see how I use earnings and Price/Earnings ratios to help establish a price target? Do you use price targets?