The PE question

I received the following question from Vincent recently.

Hi Unclez, I have been following your blog for quite a long time, and I am impressed with your long term value investment. I have bought Presbhd before Bonus Issue and I sold it during last year December sell down in the view that the earning was reducing and PE was quite high as well. I then told myself to buy back when the price back to the reasonable PE, which might be around 20. But since then the price has gone up until now PE around 90. I missed the boat along the road, or perhaps I should not sell at first place. Can you enlighten me what strategy should be implemented when we are seeing high PE stock, why some stocks already traded at high PE still can go up, whereas some like Gadang before went up recently has Low PE last time but the share price didn't move much. I believe both Presbhd and Gadang have bright future growth, and I can categories Gadang was undervalued share with Low PE. But how about Presbhd and Dsonic? Hope to hear from you and appreciate your views very much as I am still learning in stock market. Thank you.

What attracted me is the question of PE. Many people had asked me this similar question and they are looking for a sensible answer. PE is a ratio number. Simply, price of stock divides by earnings per share. The P, we usually take current price while the E, we take last year full year earnings. That lies the problem. PE ratio become "history" number. Thus, it is not a very good yardstick to determine whether a particular stock is pricey or otherwise. I prefer to use prospective PE, meaning base on future earnings rather than last year earnings. And that is the challenge. Everyone can have last year earning numbers but no one can be 100% sure of further earning numbers. So how. you may ask? Well, let's put it this way. Stock market is not a fair game. The person who makes the most money is the one who knows the pulse of the company. Sadly, ordinary retail players have this disadvantage. They mostly rely on analyst's report.

My friend, a chief fund manager, had described the characteristic of PE in a more academic but plain way. He said if the earnings of a stock is expected to improve next year, for example, the market would have priced this in and hence, the stock would starts to run. But since the earnings of the stock has yet to be delivered, naturally the P component of the PE ratio would rise first, making the PE number high. Subsequently, when the earnings are really delivered, the E component goes up, thus reducing the PE valuation. However, and this is the most important part, if there is another round of earnings growth, the P goes up again, raising valuations. UncleZ always looking out for this "another round of earnings growth" with the help of knowing the pulse of the company.

PEs are about long term averages and made up of extreme highs and lows. Low PE stock does not guarantee for good price action but does give certain comfort level than high PE stock. Stock market works in mysterious way. To be successful in stock market, PE is just one of the tool to use but not and cannot be the only tool to use to decide your investment action.

Anyway, you had sold stocks and made profits, that is good and fine. Atleast you have won the market, not losing to it. And that's the goal. What you have missed out is probably the question of big win or small win. But it is still a win. Well done.

So, Vincent, I hope this enlighten you.

Good luck.