Last time, I mentioned the importance of P/E ratios. However, the ‘E’ par—earnings—is a bit problematic. It tells you how well the company did last year – but investment is obviously a forward-looking activity. The value of a company (and therefore its stock price) in the long run is determined by the future profits it can make.
Sometimes, stocks are underpriced—such as virtually the entire Korean stock market back in 2003 and 2004 (which is why Warren Buffett used to like it so much)—and sometimes they are overpriced, such as internet stocks in 1999 (which is why Warren Buffett stayed away from them).
So what you want to think about is, ‘how will this company be doing next year, and in five, and ten years’ time?’ Samsung Electronics, for instance, will make more money this year than last year. If it keeps strongly increasing its profits every year, a P/E ratio of 17.6 today might not be bad. There are stocks with P/Es of 5 or 6, but with declining profits, and uncertain futures. That is why most of those companies are so cheap. Samsung Electronics will never be cheap, because it is as solid as a rock, keeps growing, and bosses entire industries like a playground bully. As a shareholder, you want that.
The question is, at what price? 17.6 looks pretty fair to me, judging by what similar mega-firms go for. If it were 30, I would avoid it like the plague. If it were 5, I’d sell everything I owned and put it all into Samsung.
Some people—and indeed, some very clever people—believe in ‘efficient markets theory’, which comes in different versions, but basically states that stocks are fairly priced, and you’ll therefore never be able to achieve a better than average return. My view is that they are fairly priced most of the time, but that occasionally, the market is wrong. Sometimes, stocks are underpriced—such as virtually the entire Korean stock market back in 2003 and 2004 (which is why Warren Buffett used to like it so much)—and sometimes they are overpriced, such as internet stocks in 1999 (which is why Warren Buffett stayed away from them).
In my opinion, stock investment is all about finding something undervalued—something better than other people think it is. Your hope is that later, other people realise what you realised first, and your stock goes up. That’s the idea, anyway…
One quick point before I go. This is all really basic stuff, so to avoid alienating those who must be reading this thinking, ‘yeah, and the Pope is Catholic’, I’ll pontificate about something else next time.