Tuesday, July 3, 2007

Room for Error?


Are you leaving enough room for error in your stocks? If your stock misses an estimate on their quarter do you have it covered? Or are your estimates so high that any misstep could cost you BIG.

I was flipping the channels the other day and landed on CNBC the Mad Money show (Jim Cramer) he was talking about undervalued stocks etc.. (I DO NOT FOLLOW JIM CRAMER IN GENERAL THIS WAS JUST AN INTERESTING THOUGHT SO I THOUGHT I WOULD PASS IT ON.)

One of the ways he likes to look at that is by comparing the P/E ratio with the growth rate. (The following is NOT word for word of what he said but the general idea of it.)

For example lets say the company is a $10 stock and has $1 in earnings. Or a Price to earnings(P/E) ratio of 10. (P/E is price of the stock divided by the earnings of the stock) The company is growing at 20% a year. So in theory if the company grows at 20% for the coming year they would earn $1.20 per share. If they again had a 10x P/E ratio that would now be a $12 stock. So you would have made 20% on your money.

Now lets say we have a different stock this stock is trading $100 a share. It has earnings of $5 a share. So it has a P/E ratio of 20x. Now lets say this company is only growing at a 10% rate. So next year in theory they would earn $5.50 per share. If they again had a 20x PE they would be a $110 company you made 10%. However in this example you are paying a P/E ratio TWICE the growth rate.

His point was if you can find a stock that has a P/E ratio lower then or equal to the growth rate of the company you may have an undervalued stock. IE the PE is 10x and growth rate is 20% (lots of other factors go into it just one idea to look at) And if you have a stock that P/E is 2x the growth rate you have an overvalued stock. IE P/E is 20x and growth rate is 10%.

That is an interesting and I think wise way to look at things. (Again not the only thing to look at)

But what I would like to add is are you leaving ROOM FOR ERROR?

Are your estimates so high for the stock that even a little hiccup could drive down the stock price HUGE!

Are your estimates for a perfect 10Q no hiccups in inventory, or sales glitches, or bad sales because of XYZ. If your estimates are so HIGH then you may end up getting crushed. That is why I like to put a no higher than 15x PE on a stock. Even if the stock is in an industry where the average PE is 25x. I am giving it room to move to the downside if they have a bad quarter.

Any example of that, is someone asked me the other day to give my opinion on a certain stock. (I won't mention it to protect the innocent.) The company had good price to sales and price to book ratio. The company however had a 16x PE right now and are only growing at 6-7% a year. (It also had some other factors I didn't like) But you are basically paying this high premium for a stock to perform perfectly. One bad move by the company and that growth rate becomes 0% or maybe on the negative growth.

Saying XYZ stock which is a small cap stock deserves the same PE ratio of Microsoft is stupid. And an easy way to lose money.

I thought I had left room for error in the 3 stocks I owned last week. But they have to be reevaluated each time news comes out from the company.

On HIHO I had no idea they would post negative earnings.
My estimates were obviously way to high. The company has traded well since the news though only down about .30 or about 7%. Although I didn't think I left room for that big of error the market has held nicely on that stock. Maybe due to the low float and the fact of a dividend is coming shortly. But I still have to reevaluate after news. And the figures that I come up with just don't bare out the current levels or much higher levels. That doesn't mean it won't go up. It just means I am no longer comfortable with the stock at the prices it is commanding.

On CAGC the earnings and sales estimates are still all in line. The problem is the issuing of 5.5 million more shares. Which drops EPS down about .11 per share. The company is growing at a fast clip and they can use the money they get from the private placement well I am sure. The downside still isn't that great on the stock unless of course they don't earn what they say they are. But if they do earn .33 EPS for the year at a 10x PE its still a $3.30 stock. So I don't see a lot of downside in the stock like dropping to $2 or something but the upside is much slower at least for what I am looking for. That is a stock I would consider jumping into though if I felt more comfortable again with it. I just got hammered with 2 shocking news hits out of 3 stocks I owned on friday I felt I better dump it before it got out of control.

Have I left enough room for DFNS????
I don't know I will probably call DFNS later this week and get some information on things are going etc.. Unless they never get rid of their backlog or can't make a profit on their backlog I dont see a lot of downside to the stock. I do think this 2nd quarter will tell the story. If they come out with no earnings or negative earnings or even only .01 EPS for the quarter the stock may get hammered. I am excepting a very good quarter but are my estimates too high am I leaving room for error?

We go over all the statistics we look for when finding a stock for the stockdoubling project in our Videos at www.BeforeItMoves.com

FYI today July 3rd the stock market will close early today (1pm I believe) and will be closed on July 4th.

Have a great day.
Steve Hoven

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