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The stock metric you'll regret overlooking

March 26, 2014

| MoneyRates.com Senior Financial Analyst, CFA

The ups and downs of stocks can make the market feel like a popularity contest at times. This company is trendy, so people are buying, whereas this one has a negative buzz about it, so people are selling. Sometimes it is wise to tune out all the chatter and focus on what really makes a stock worth buying: the earnings.

After all, if you were buying a business, you would pay more attention to the numbers than the buzz about the company. Buying a stock should be no different.

Paying for growth

Perhaps the biggest difference between buying a publicly traded stock and buying a private business is the extent to which stock buyers are paying for future growth. The S&P 500 is currently are trading at a price-to-earnings (P/E) ratio of more than 18, which means the earnings yield on stocks is about 5.5 percent. That may be a lot better than savings account rates, and a little better than bond yields, but it also comes with a great deal of risk. Growth prospects are really the only thing that justifies taking that risk.

Put is this way: Can you think of a company in your town that you would buy at a price of 18 times the current year's earnings? Private market transactions usually do not occur at anything close to that high a multiple. So, when you buy a stock, you are not just paying for the company's present. You are paying for the future, so you need to have a clear sense of just how a company's earnings are going to grow into the expectations that are inherent in its price.

Top-down vs. bottom-up

The disconnect between investment activity and fundamental analysis can be seen in the divergence between top-down and bottom-up earnings estimates for next year. Standard & Poors compiles the earnings estimates Wall Street analysts make for the various stocks in the S&P 500 and averages them. In addition to these stock-by-stock estimates, which are known as bottom-up estimates, there are top-down estimates, which are arrived at simply by projecting an expected growth rate to the overall earnings of the S&P 500 index.

For most of next year, those top-down estimates are running about $3 to $4 ahead of the bottom-up estimates. That means there is a general level of optimism about earnings growth that is not supported by the analysis of individual companies. That should be enough to give investors pause.

From a whisper to a scream

Finally, it is critical to focus on both price and earnings when buying a stock. You may be absolutely right about a company's growth prospects, but if the price already reflects a similar level of optimism, you could have everything go right and still not make any money.

Do not assume that the market has failed to appreciate a company's potential just because Wall Street earnings estimates seem modest. Often, what are known as "whisper estimates" can drive a stock price up. This is when analysts have not formally revised their estimates, but are letting people know they think the stock will actually exceed their estimates.

In short, whisper estimates are a form of Wall Street buzz -- and those whispers can make Main Street investors want to scream.

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