Investing Advice AGAINST Future Earnings and Trend Lines

Discussion in 'Chit Chat' started by Justo, May 23, 2011.

  1. Justo


    Last Thursday I watched a segment on BNN in which the co-host (some Asian man) kept valuing stocks based on their forward earnings. He talked about how the price was undervalued or overvalued or on par with what the company was expected to earn in the future. Some of his valuations were even ¡§justified¡¨ by selling (in his words) at ONLY 10X forward earnings. Are you kidding me?!?! These are absolute blasphemous words to the value investor, which I will delve into in a moment, but first I must issue a warning to ANY and ALL investors that believe this.

    *WARNING * By basing a stock¡¦s price on forward looking statements you will (most probably) lose your money!

    And here¡¦s why:

    Basing a stock¡¦s value strictly on future earnings is ridiculous in that we do not know what those future earnings are! Are you a fortune teller? A psychic?? An enthusiastic optimist??? They could be less or more or the same as they are now couldn¡¦t they? So by this very notion we are either speculating or can see far into the future, in which you should already be a very wealthy individual (If I was psychic I would win every lottery ticket and win every sports bet I made).

    ¡§But wait!¡¨ they¡¦ll say. ¡§We can make a trend line to show that future earnings are going to be greater than they are!¡¨ Let me make this clear. Trend lines are for people who do not believe in change, and this attitude will ultimately lead to failure in the stock market. They have no notion of the idea that those which often go up must come down. If we were to take a trend line as absolutely true, then we are saying that the stock market is strictly based on mathematics. And if this is true, then trend lines would work.

    However, IF this is true then a trend line going up must go up to infinity, and a trend line that is going down must also decline forever. You¡¦re catching where I¡¦m going with this I hopeƒº. Stocks do not go on like that forever, they fluctuate and advance and decline and do all sorts of crazy things. To think that a stock¡¦s price can only keep advancing is foolishly optimistic, and a person with this mentality deserves to lose every dollar that he owns. If we could rely on trend lines it would make investing extremely easy and everyone could be a mega billionaire, as stocks that were going up would continue to go up forever making the price of that stock infinite. Stock investing then cannot be based entirely on mathematics or trend lines, nor can it be based strictly on news alerts or management (which we will not talk about today). To roughly quote Ben Graham ¡§Stock investing is neither purely mathematical nor purely artistic, but lies somewhere in between.¡¨

    Let¡¦s break down what this Asian man was trying to say though, just to get a better understanding on what he means. He is saying that based on the trend he sees future earnings growing from $1 to $2. We would then use this $2 figure, multiply it by 10, and get $20 for the price of the stock that we would currently pay. So we would pay $20 now to receive something that makes us $1. In reality we would be paying 20X current earnings! I don¡¦t have to tell value investors that this number on its own would grossly overvalue the price of a stock. If I told you that in the future $1 would be worth $2, would you pay me $1.50 right now for something worth $1? Heck no you wouldn¡¦t!!! You would pay me $1 for something worth $1. Be wary of any investor who tries to sell you stock based on future earnings.

    An example of how foolish it is to base a stock¡¦s price on future earnings or trend lines can be seen in the case of Worldcom. If we took the trend line for Worldcom between 1992 and 1999 we see that the stock advanced from about $30 per share to a high of $63.50! If we continued this trend by 2011 the stock price would be roughly $121. So how did Worldcom do?
    Well by the end of 2002 the stock was trading below $1, during which the company soon filed for bankruptcy.

    In conclusion, it is absolutely and utterly ridiculous to base a stock¡¦s price based on future earnings. While some investors may make money by using this system, many will succumb to an annihilation of their principle. It is far better to evaluate a stock¡¦s price based on a value approach, as this will offer a greater safety of principle. (I¡¦ll cover aspects of this in the future). It hurts me to see people losing money, so please, stay away from anyone who talks about basing a stock¡¦s current price on future earnings or trends. Good luck!