Price earning band can expand or contract

This little thing called PE Band

When market falls, it is common to hear people saying that they are eager to go “shopping” for fundamentally good stocks where prices have fallen by 20% or more.  

I am not against fundamental analysis (FA), but would like to point out one thing about FA that we must remember, and it’s something called price earnings (PE) band.

Very simply, when market is in bullish mode, analysts and investors are willing to give higher PE valuation to a stock than they previously did.  For example, a stock with earnings per share (EPS) of 5 cents were previously trading at 50 cents, so at PE of 10X.  When market is bullish, analysts raised the PE accorded from 10X to 20X, the PE band is expanded and the stock could potentially trade up to S$1 instead.  The problem with this is that it is very “subjective”…..analysts and investors can CHANGE the PE band anytime with their own justification or reasoning, which is often related to market sentiment.

As we see it now, when market sentiment is bad, even though the company’s outlook may remain rosy, the PE band previously given to the company may have contracted this time round from let’s say 20 times back to 10 times.  Which is why even if some company continue to deliver positive results ie fundamental remains strong, the stock price may not trade back up to those levels we saw earlier this year due to PE band contraction.

So before you go “shopping”, make sure you reassess the PE band of those fundamentally good stocks….my guess is that they are unlikely to trade back up to those PE band that we saw in the near term due to weaker market sentiment.

To be “kiasu”, look for stocks with single digit PE, especially if you can find those trading back to 5X forward PE and with good growth potential, then the down side could indeed be limited.  Let me know too if you come across any

Article by Rooney