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

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

Transcript:

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.

Thoughts on this article? Leave a comment below.

An Alarmingly Good P/E Ratio

Matthew Carr’s VIPER Alert service finds companies with a mix of metrics that indicate rapid future growth.

One of his recent recommendations is Alarm.com (Nasdaq: ALRM). Here’s Matthew checking on the pick back in August...

Alarm.com currently has 1,400 service provider partners, with more than 900,000 subscribers.

And in the second quarter, the company launched its own indoor and outdoor security cameras for homes and businesses. It’s seeing doorbell cameras being ordered in one out of every eight installations - and security cameras in one out of every five.

So it’s looking to boost hardware growth as well. And camera installations are up from the 12% to 13% it was at last year.

Alarm.com is forecasting full-year revenue between $326.3 million and $327.8 million. At the midpoint, that’s an increase of 25.3%.

So let’s go over what VIPER looks for...

Value: Shares of Alarm.com are currently more than 4.2% below their 52-week high of $42.48. The company currently has a price-to-book ratio of 8.87, higher than its peers’ average of 5.88. And its price-to-sales ratio is 6.22, also slightly higher than its peers’ average of 5.77. But Alarm.com’s revenue growth, profit margins and operating margins are more than double those of its industry peers.

Income: Alarm’s non-GAAP adjusted net income has gotten increasingly better over the last couple of years. In 2014, it grew a mere 1.6% over 2013. But in 2015, it was up 22.7%, and in 2016, non-GAAP adjusted net income grew 48.8%. In the first quarter of 2017, this surged 79.9%. And in the second quarter, it skyrocketed 123.8%.

For the year, I expect this to increase more than 53% over 2016’s non-GAAP adjusted net income.

Profits: Alarm.com’s trailing 12-month price-to-earnings (P/E) ratio is 104. That seems high but is below its industry average of 107.7. And the company’s forward P/E is 41.41.

Earnings: Non-GAAP adjusted net income per share fell 75.5% in 2014 and tumbled another 53.6% from there in 2015. But last year, this increased 29.4%. And in the first quarter of 2017, it jumped 76.9% and then 120% in the second quarter.

For the full year, I think the non-GAAP adjusted net income per share will be up at least 47%.

Revenue Growth: Revenue growth has been increasing at a solid 20%-plus pace for the last three years. For the full year, the company is expecting revenue to be up 25.3%. But I think it could be even better at around $330 million. In the first quarter, revenue increased 25.7%. And in the second quarter, it grew 33.5%.

- Samuel Taube with Matthew Carr

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