Are Appraisals Precise?

The

appraisal

that the financial community gives to a company’s own characteristics is of extreme importance in the price earnings ratio than in the appraisal of the industry in which the company is involved in. Generally the closest that the financial community’s appraisal comes close to the characteristics of the different aspects of a conservative investment the higher its

price earnings ratio

will be. The amount by which it falls under the standards, the price earnings ratio then has a tendency of declining. An investor is able to determine which stocks are very undervalued or overvalued by a perceptive determination of the extent that the actual facts about any particular company present an investment situation considerably better or considerably worse than the one that has been shown by the present financial representation of that particular company.

When determining the relative attractiveness of two or more stocks, investors sometimes mix themselves up by making too simple of a mathematical approach to this sort of problem. Let us imagine for instance, that investors compare two different companies and look into the profits of each of the companies which, after they have looked and studied them carefully, look like they will bring about growing at a rate of ten percent every year. If one of the companies is selling at ten times earnings and the other company is selling at twenty times earnings, it would seem that that the company that is selling at ten percent earnings is cheaper and in some cases this might be right; however it could also be wrong. There can be a diverse amount of reasons for this. The company that seems to be cheaper could have such a leveraged capitalization that the hazard of sudden break of the hoped for growth might be a lot greater in the lower price earnings ratio stock. In the same way, for solely business motives, even though the growth rate would seem like a more credible estimate for both stocks, nonetheless the possibility of the unforeseen disturbing these estimates might be quite a bit more for one stock than it may be for the other.

One other much more vital and much less understood method of getting to the wrong conclusions is to lean too much on straightforward judgments of the price earnings ratio of stocks that look like they are offering comparable opportunities for growing. To better explain this, we will imagine that there are two different stocks that have the same strong prospect of doubling their earnings within the following five years and that both of these stocks are selling at twenty times earnings, even though in the same market there are sound companies but these ones do not have any growth prospects and are selling at ten times earnings. Then let us imagine that during that same time, five years afterwards, one of the two stocks has the same type of growth prospects for the upcoming years as it did during the same time, five years ago that is before so that the financial community’s appraisal is that this particular stocks should one more time double its earnings two times within the following five years. In other words, this would mean that it would still be selling at twenty times the doubled earnings of the past five years; this also means that it has also doubled in price during that stage. On the other hand, during this same time, five years after the example had begun; the second stock has doubled its earnings as well, just like what had been prospected, however at around this point in time, the financial community’s appraisal is that it will have flat earnings during the following five years in a company that is otherwise sound. In other words, the owners of the second stock had a market disappointment coming their way even when the five year doubling of the earnings had occurred just as it has been foreseen. Now that they have an image that there will not be any growth for the following five years, these investors would only be looking at a price earnings ratio of only around ten in the second stock. As a result, even though the earnings had doubled, the price of the stock actually stayed exactly the same, all of this can be summed up in an investment rule that is very important which is that the more into the future profits will keep on growing, the investor will be able to pay more of a higher price earnings ratio.

This rule, nonetheless, should be used in a very careful way. Always keep in mind that the real variations in price earnings ratio will not come from what will actually occur, but from what the financial community believes will take place right now. During a time when there is general market optimism it is possible that a stock will sell at a very high price earnings ratio since the financial community very correctively predicts a good number of years of very good growth in the future. However, a lot of years will have to go by before this growth is completely realized. The big growth that had adequately been discounted in the price earnings ratios will very likely turn into an undiscounted for some time, especially if the company goes through the kind of momentary set back that is common to see even in the case of the best companies. During the times when there is general market negativity, this type of turn around of some of the very best investments can get to pretty extreme levels. When this does occur, it gives the investor the ability to be able to differentiate between present market image and actual essentials, and which are some of the best opportunities common stocks is able to provide for nice looking long term profits at very low risk.