Saturday, November 1, 2008

why EPS, PE in stock valuation ?

There are 2 main factors why a stock price goes up and down:
1) fundamental strength of that business ( Strong or Weak )
2) general public view points ( Positive or Negative )
So there are 4 combinations:
Weak Company Negative Views : Price Drops Continously
Weak Company Positive Views : Price Up and Fluctuate
Strong Company Negative Views : Price Drops to substanable level
Strong Company Positive Views : Price Up and Substain
You BUY Strong Company 
during its Negative Views time (3)


You SELL during Positive Views ( 2 & 4 )

EPS or Earning Per Share shows you how much the business earn during a particular period.  Over the years, the EPS growth rate shows you how 'STRONG' the business is.  A consistently grown EPS shows that the business is able to conduct good business despite good or bad times.

PE or Price Earning ratio basically describes how many times a stock price is traded comparing to its earning.  For example, a business may be earning $1 now but its stock price is traded at $10, PE = 10x.

One of the usefulness of this PE is to show confidence level.  For example if I compare 2 businesses of the same nature, one is traded at 10x while another is only 5x.  That shows that general public is more confidence with one business than the other.

I can also examine all the PE numbers for all plantation stocks ( same industry ) and come up with an average or normalize PE, says 8x.  Then compare to the PE of the particular stock I am planning to buy, says 10x.  Then I know many others are also interested in this stock compare to other stocks within the same industry.

If I keep a historical record of PEs, I can also understand the stock price trend better.

So that is why I use EPS and PE, this combination tells me both the company strength and what the market thinks about this business.