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The combination of falling earnings and rising stock prices has some legendary investors sounding alarm bells over stock valuations. Druckenmiller worked along side George Soros before founding his hedge fund Duquesne Capital.
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Determining whether valuation is a problem requires knowing a little bit about what Wall Street looks at when valuating stocks. Every profession loves its acronyms.
Wall Street is no different. Acronyms can be helpful, but they can expensive earnings on the Internet confuse. Tesla ticker: TSLA CEO Elon Musk once famously banned acronyms in employee emails, pointing out that it was often simpler and shorter to spell out the associated words. He was likely right.
Falling earnings, higher P/E
Still, understanding industry jargon makes people insiders. PE ratio is probably the best known bit of Wall Street jargon.
PE, of course, is short for price-to-earnings and compares a stock price against its per-share earnings.
It is now above 20 expensive earnings on the Internet estimated earnings.
That is a problem, but there is the hope that earnings are an outlier. Seventeen times is still a little high, historically speaking, but PE multiples are also tied to interest rates. Stock returns are linked to all other returns on a relative basis.
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There are limits to this idea, but falling interest rates tend to push up PE ratios. The 10 year U.
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Sometimes when earnings are in flux, like now, investors will look at the PS, or price-to-sales ratio. Top-line sales are less volatile than are earnings.
It is a helpful metric when profit margins are depressed. The market is trading for about two times sales, up from 1 time sales during the financial crisis. The PS ratio is elevated versus history, too, but the same point about interest rates applies to all valuation metrics.
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Growth rates matter and so do returns. Faster-growing stocks trade at higher PE and PS multiples.
And companies with a high, or improving, return on invested capital also get higher valuation multiples. The level and change in return on invested capital, such as shareholders equity, is a sign of the health of a business and what kinds of earnings are coming down the road.
Pay attention to P/E
Returns on equity are cyclical, like the economy, but have been trending higher. Whether returns can go even higher is a debate for another day. Another fallout from the pandemic is higher debt. Sometimes, when looking at highly leveraged companies, investors will look at enterprise value, or EV, which is essentially market capitalization plus net debt, compared with Ebitda, short for earnings before interest, taxes, depreciation and amortization.
Ebitda is a great bit of Wall Street Jargon. Ebitda is a proxy on cash flow. It is the amount of money companies have available to buy equipment as well as pay interest on their debt and, of course, dividends.
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Cash, as they say, is king and cash flow is what matters in the end when valuing stocks. In fact, all valuation metrics are just proxies—or short cuts—to help figure out how much cash an investment will bring in. Any asset is worth the cash received from it, discounted back at an acceptable rate of return.
If only it were that simple. Still, knowing this amount of jargon is enough to get them in the club. Write to Al Root at allen.