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Get prepared for another jump in volatility as earnings season gets underway again. Because it’s coming.
Alcoa (NYSE: AA) kicked off yet another earnings season when it released earnings after the closing bell last Wednesday. And this season should keep you on your toes. Especially if you’re invested in small caps.
During last earnings season many of the small caps I follow were jumping around like crazy leading into, and coming out of, earnings announcements. I think the underlying reason is that the market is trading near the high end of its “normal” valuation range.
The Russell 2000 small-cap index carries a forward price/earnings ratio of 19. That valuation implies that many of these companies are expected to keep growing at a healthy rate. Otherwise, there’s little incentive to pay a premium for shares.
If revenue, profit margin and earnings per share (EPS) growth are good, then that relatively high P/E should come down as actual reported earnings catch up. But if all of those metrics come in below expectations when companies report second quarter results, then that P/E will look even more inflated.
With this in mind, there are a few financial metrics that you should follow when trying to decide if a stock is attractive this earnings season:
Price/Earnings Ratio
It’s not a stretch to say that the P/E ratio is the most embraced metric for valuing stocks. The P/E ratio is used to value companies based on their past or future earnings, and it can help you determine whether a stock is overvalued, fairly valued or undervalued relative to the stock market as a whole.
To calculate, simply take the share price and divide by the EPS over a 12-month period. You can use EPS over the last 12 months (also called trailing 12-month P/E), or the expected EPS over the next year (also called the forward P/E ratio).
As a general rule, high growth companies will carry high P/E ratios, because investors are willing to pay a premium for earnings that will outpace the competition. As companies become larger, their growth rates often decline. And as the growth rate slows, the P/E ratio typically declines.
Ideally you can find small companies that are growing fast, yet carry relatively low P/E ratios. But that’s hard to do in this market. So use a benchmark of an appropriate index, like the Russell 2000 for small caps, and competitors in the same industry, to see if the stock in question is relatively cheap, expensive or fairly valued.
Price/Earnings to Growth Ratio
To step up your game one notch, try checking out the P/E to growth, or PEG, ratio. This is easy to calculate once you have the P/E ratio in hand. And it’s helpful because it takes the company’s rate of earnings growth into account.
To calculate, simply divide the P/E ratio by the annual EPS growth. Make sure to match up periods. So if you calculated a trailing 12-month P/E ratio, also use EPS growth over the last 12 months. And if you’re using a forward P/E ratio, use estimated EPS growth over the coming year.
While the PEG ratio can be used on its own, it is helpful to compare PEG ratios of companies within the same industry to get a relative value. And as a general rule, a PEG ratio below 1 is a “good” value, while a stock with a PEG ratio over 1 indicates a comparatively more expensive stock.
Rate of Growth
This is probably the easiest, and most important trend to study. And you can use it for almost any line item on an income statement, balance sheet or cash flow statement. Just compare the percentage increase from one period to another and you have your rate of growth (or rate of contraction).
I tend to focus on revenue and EPS growth. But the rate of gross and net profit margin expansion (or contraction) is important, too. And depending on the company, you can check out growth rates for industry specific things – such as the rate of growth in research and development spending for a tech company.
As a general rule, I like to see a company growing revenue and EPS above that of the broad market. This suggests that the stock should be a strong performer, although a stock’s valuation is obviously a key part of the equation, too.
Faster growth is only worth paying so much for. And the P/E and PEG ratios can help you determine what’s “fair.”
Determining fair value and analyzing financial trends is equal part art and science. There are always exceptions to the “rules.” But over time any investor with a calculator will be able to get a better sense of whether or not a stock is an attractive buy, simply by calculating these simple metrics.
If you haven’t done this type of financial analysis, give it a shot this earnings season. It will help you better understand why some stocks are more volatile heading into, and coming out of, earnings. And it will make you a better, more informed, investor, too.
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