Getting the Market Right: Matthew Carr Explains Price-to-Earnings Ratios

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club


Steve McDonald: Our guest this week is Matthew Carr, the single highest-producing analyst, stock-picker guru The Oxford Club has ever had.

Matthew Carr: Thank you!

SM: What’s your highest gain ever?

MC: 2,733%.

SM: On one pick?

MC: On one pick.

SM: And you didn’t call me?

MC: No, I didn’t.

SM: The topic is forward and trailing P/E. Let’s start with P/E. What’s P/E, and why do you use it?

MC: All right, so P/E is price to earnings. That gives you a ratio of, basically, the premium that investors are willing to pay for every dollar of earnings a company produces.

Trailing P/E is just that - it’s looking backward. It’s looking backward at the last four quarters.

SM: And that’s the one that shows up... When you pull up a quote on Yahoo Finance, the trailing P/E shows up?

MC: Yeah. The trailing P/E is sort of like the standard for the industry. And I think it’s an okay measure; I don’t always put the most weight into it.

A lot of people have certain rules where they’re only going to buy companies that have P/E’s of 18 and a price-to-book value of 1.5 or better. There’s no hard-and-fast rule about what’s a good P/E, because every industry is a little bit different.

SM: Yeah, I mean things like Amazon (Nasdaq: AMZN)... What’s Amazon’s P/E?

MC: Uh... high.

SM: Yeah, it’s ridiculous. The market average is 18. It must be over 100 now, isn’t it?

MC: Yeah. And a lot of the tech stocks will have...

SM: There are scary P/E’s.

MC: Yeah, there are several. I’ve even recommended a company one time that had a 1,000 P/E. Because to me, that’s looking backward.

SM: Yeah, way back.

MC: Because you’ll see a company that goes from making a penny [in earnings per share] one year, and it’s traded at a very high [P/E], and then it goes forward to making a lot more than that - over $1.50 or something.

So for me, trailing P/E is the standard, but what’s the most important is the forward P/E number. Because that forward P/E number is going to give you what the shares are priced at compared to future growth.

And you can always do a really easy calculation to see how much growth you can expect by just taking that trailing P/E and dividing it by the forward P/E.

SM: Oh, I’ve never done that.

MC: Yeah, that’ll give you - and it’s a real quick calculation - that’ll give you the percentage growth.

And the No. 1 rule - and how you can use these two together - you always want to have a trailing P/E that is higher than a forward P/E, right? Because that means the company is growing. The future earnings are growing more than what they are now.

If the forward P/E number is higher than the trailing P/E, the company is shrinking, and you want to avoid that.

So those are the two great things that I like to use with that, and it’s a real quick step that any investor can take.

SM: Where do our Members find this stuff?

MC: So [trailing] P/E, as you mentioned, is always going to be on that front screen, because it’s the standard.

Forward P/E... you’ll have to look. Some sites will have it. I think Morningstar will post it further down in the data. For a site like Yahoo Finance...

SM: It’s under “Statistics.”

MC: Under “Statistics.” You’ll see that there.

SM: It’s one of the little prints under there.

MC: Yeah, it’ll be right there with price to book, price to sales, so forth and so on.

SM: Give us an example of a stock you’re looking at now with the forward and trailing P/E.

MC: Well, there was a company that I just did - Vipshop Holdings (NYSE: VIPS), which is a Chinese e-commerce company. I don’t have the trailing P/E...

SM: What was the forward?

MC: I don’t remember what the forward was...

SM: But there was a spread?

MC: There was a spread. And that’s what I’m always looking for, is to make sure that there’s a big enough spread.

So actually, in the VIPER System, that is one of the pieces that we use, is looking at that trailing P/E to forward P/E.

SM: So if we have a market average of 18 right now for trailing P/E, a forward P/E is pretty high... you’re into the 20s.

MC: Hmm. Oh, you mean...

SM: If a company is right at the market average P/E right now, at 18...

MC: Mmhmm.

SM: And you want a spread of at least two or three points...

MC: Yes.

SM: You’re up to 21.

MC: Well, you want that forward P/E to be much lower. You want the forward P/E to be near 15.

SM: So you want it down to 15. You don’t want it higher.

MC: Yeah. Exactly.

SM: Forward and trailing P/E. It’s one of the first things I look at when I’m trying to pick a bond or a stock for myself. And I really appreciate your coming in today.

MC: Hey, thanks for having me, Steve.

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