Do you take P/E ratios as stated from your sources or do you adjust to normalise earnings? Is there a way to do this in any automated fashion?
We adjust the heck out of them for things like non-recurring charges, discontinued ops, cyclicality (depending), and a host of other things. Generally never, ever, ever trust sources as stated when we’re actually doing due diligence. We will use stated P/Es occasionally as a screening/sorting/filtering tool for idea generation in the very preliminary stages of research.
Thanks SSF. Could this be automated to any degree i.e. if you had the annual reports in excel format from Edgar or Bloomberg? Then you would have the adjusted / clean data to start screening/sorting/filtering from. I know you obviously have to dig into the 10Ks/10Qs and annual reports to find the information to do the adjustments, but would imagine there is some standard lines that you tweak. Looking to 'demanualise’TM this process if at all possible…
Bloomberg has equity screening capabilities with a simple language you can learn to enter in different items on the balance sheet, income stmt, etc. Sounds like you might want something like: [Current price / avg of last 5 years earnings, where earnings have been adjusted to exclude one-time gains/losses] is less than (a number that you want to use - current P/E of the market, or some other value you have in your head). I forget what it is, but I think bloomberg has a set variable for “earnings, excluding one-time charges/gains”. It’s not perfect, but it’ll filter out some of the non-recurring crap. You could then then use this as a starting point for your screens, but this is really not much more than a starting point. You’d have to combine it with other metrics (market cap, leverage ratios) etc in order to get your list down to a usable universe.
Some people also make different adjustments depending on the industry. This seems to me to be a hassle for someone writing code. Also, FYI that most academic analysis of valuation ratios exclude Finance, Utilities, REITs, and a few other smaller components from the Compustat data. Off the top of my head, I wasn’t aware of any academic research that cleans Compustat data for things like non-recurring items or normalizing earnings on a firm-by-firm basis. There certainly is plenty of literature on earnings quality and accruals. Did some googling and found this, also has some references that might be interesting: http://www.northinfo.com/documents/188.pdf
ssf, but by using the given P/E rations in your preliminary screenings, aren’t you filtering out potentially valuable (or looking at it from the other end of the spectrum, worthless) stocks that do/don’t make it into your initial list of stocks to review?
I thought they used FCF as the main valuation metric rather than earnings, or am I mistaken?
mp2438 Wrote: ------------------------------------------------------- > ssf, but by using the given P/E rations in your > preliminary screenings, aren’t you filtering out > potentially valuable (or looking at it from the > other end of the spectrum, worthless) stocks that > do/don’t make it into your initial list of stocks > to review? You are 100% correct. That would be why this type of screen is only one of several methods we use to find ideas. Screening by P/E is certainly valid as a starting point, but so are lots of other things. The reason we use several different screens is exactly what you said - some screens will mistakenly omit stocks we would rather look at. Some will retain stocks we have no interest in. By using a couple of different screens and different methods (some of which don’t start with screens), hopefully we don’t exclude too much of the investment universe, but we hopefully *do* make a little progress in determining what sectors and companies are starting to get ‘cheap’ by a number of metrics. Any one ratio won’t be enough to form a judgement about a company, but if a company appears cheap by a good number of metrics, then it’s probably starting to hit the “could be interesting” area of valuation that means we should start researching the situation. There are some very valid and interesting value investment strategies that unfortunately nothing in a screen could detect. For example, if a company carries land or an investment on the books at cost, and the owned land or company is worth well in excess of carrying value, then that’s a hidden asset. Screens won’t turn this up, but if you can find these types of companies, they are generally excellent opportunities.