How Do You Value a Stock?

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How Do You Value a Stock?

We left off last week talking about the market being at a 2-year high. That means stock prices are up big over the last 24 months, with the Dow and S&P500 almost doubling from the bottom in March of 2009. But just because stocks are up doesn’t mean they are expensive. Sounds pretty weird, right? It’s time for us to talk about valuations.

Let’s kick this conversation off with a question.

Let’s say you have two very similar companies standing side by side, both with a share price of $50.

How do you choose which company to buy?

All things being even, that’s simple. You buy the one with the most earnings.

That’s it, we’re done, class dismissed.

You Now Understand Valuations

Everyone now understands valuation, the simple art of looking at a company’s earnings instead of its share price. In the world of geeks that’s called a P/E ratio, but that’s just technical mumbo jumbo designed to keep the wizard behind the curtain. A low P/E is better than a high P/E because you are getting more earnings for each Dollar invested.

But it’s not always easy to practice, because a low share price can be tempting. Seeing your favorite stock dip from $21 to $15 can make your heart race.

But before you pull the trigger and unload a few rounds, it’s important to take a look under the hood to see what kind of shape the engine’s in.

Remember, share prices don’t live in a vacuum, they move for a reason. If shares fall but earnings don’t, it’s a buying opportunity. But if earnings fall with shares, it’s the exact same investment it was before the decline.

So don’t get caught up in price action, take the long-term view and focus on earnings, a much better indicator of future gains or losses.

The Middle East is Brewing

There was no shortage of action this week, with a fresh round of political instability rippling through the Middle East. This is basically wave two, a much scarier and more brutal version of what played out in Tunisia, Algeria and Egypt over the last few weeks. Most of those evil dictators left on fairly easy terms. But this second round of evil dictators is proving to be much more vicious. The leader of the pack is Libya, whose military has taken to shooting front-line protestors in the forehead. That’s called a deterrent, as in, “you mess with us, you die.”

While the battle rages on, the two crown jewels, Iran and Saudi Arabia sit idle with fingers crossed that its legions of oppressed and unemployed stay quiet. If either of these countries gets in trouble oil prices are going to go nuts. That’s a story and market to keep your eye on.

Other than that, we heard from China again this week, raising reserve requirements for its banks. This is a move designed to cool its very hot real estate market, where the country denies seeing any signs of inflation in spite of higher multiples and big year-over-year gains. But once again, the market took it in stride, closing with its third consecutive weekly gain and spiking into the close on Friday.

Let’s take a look at our stocks.

Deere & Co. (DE)

Deere stepped up and smacked a dinger for the heartland, reporting awesome Q4 results that came in well ahead of expectations. The company said that higher grain prices are giving farmers the confidence to spend and invest in new equipment and that it sees that trend continuing well into the future. Deere also mentioned that its European markets are looking stronger than it had expected. This is the same thing we heard from McDonalds, a good sign from our international companies. Shares were up about 3.5% on the news but have pulled back a bit since. The long-term trend is still looking good though, so let’s look for the strong results and bullish forecast to support the market.

CF Industries Holdings (CF)

CF also delivered solid Q4 results, reporting earnings that almost tripled from last year. Hello higher fertilizer prices. Shares were up a couple points on the news, but things got a little dicey on Friday when grain prices had their worst performance since November on the banks news out of China. And keep in mind, the correlation between grain prices and CF’s share price is incredibly strong, so a bad day for grain is a bad day for fertilizer. Although it wasn’t fun to see shares sliding, the longer-term trend is still strong and the food and agriculture investment story remains one of the strongest in the market.

Cimarex Energy Co (XEC)

Cimarex made it a trifecta, delivering our third great earnings report of the week, with earnings up 11% from last year on higher volume and prices. Here’s a shocker; this stock has a very strong correlation to crude prices, so when crude is strong, like it is right now, Cimarex will do well. We saw some of that fresh path of political instability in the Middle East work its way into crude at the end of the week. That and the company’s strong Q4 performance gave shares a very nice boost, with shares up about 6.5% on the week.

Looking Forward

We’re going to be looking at healthcare stocks this week, one of the major themes flowing through the portfolio. We’ll be back next week to take a more comprehensive look at the sector, but before we sign off, here is another energy stock at the top of our list to add to the portfolio as the energy trade continues to look strong.

Baker Hughes, Inc. (BHI)

With political tension brewing in the Middle East and crude prices remaining in elevated territory, energy stocks are looking strong right now. Baker Hughes is a good pick in the space because the company has a strong domestic presence that keeps a good portion of its business shielded from global instability. And although the company does work with crude, its specialty is natural gas, which becomes more attractive to investors and consumers as crude gets more expensive. Categorically, BHI is an oil services company that has a weaker correlation to crude prices than a company like Cimarex, providing some diversity to our energy suite. With a market cap of $31 billion, BHI is a major player in the domestic crude and natural gas services scene.

In the meantime, here are two interesting articles to check out. The first is about the US stock with this highest valuation, a nice follow up to our valuation conversation. The second is a good article from Business Week discussing the recent surge of political unrest in the Middle East. Enjoy!

Green Mountain Coffee Most Expensive Valuation for US Stock

Bahrain Vows to Ease Tension; Mideast Unrest Spreads

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