PE RATIO IS USELESS ⚠️

The markets open lower today $SPX500 as trade tensions between China and the US continues. I wrote an article on why now is the time to invest in China. You can have a look at it. As far as our portfolio is concerned, Concho Resources $CXO is the best performer today as $OIL prices recover. GameStop $GME continues to fall. I was scared that it was rising too fast and that I'll have to sell soon but it seems that for the time being, there is no need to sell as the risk on the investment is now lower.

I made a small investment in Fitbit $FIT yesterday waiting for the acquisition by Google $GOOG . The stock price of Fitbit reached $6.68 which means that investing at that price guarantees a returns of 10%(that's the minimum I look for arbitrage) if the deal goes through. I made an analysis of the deal a few weeks ago. The link is down below. This is the second arbitrage play right now in our portfolio. The minimum gain from the AbbVie-Allergan $ABBV $AGN is now 7% ans is not that attractive for further investments anymore.

PE RATIO IS USELESS ⚠️

If you are learning about stock investing from YouTube, I'm sure everybody will tell you to look at PE ratio. Netflix $NFLX has a PE ratio of 94, therefore, it is expensive. Micron Technology $MU has a PE of 8, therefore, it is cheap. But PE ratio doesn't tell you anything and is often misleading.

Here's how PE ratio is calculated:

PE ratio = stock price/Earnings per share = market cap/net income

There is something wrong with PE ratio because there's something wrong with net income and consequently, EPS.

Net income is supposed to be the total profits of the company, that is, you need to subtract all expenses from revenues. But if you count how much cash the company actually made, you'll see that it never matches the net income. Some of the expenses don't really take cash out of the business. For example, amortization and depreciation. If let's say, a drug company, develops a drug and gets it patented for $1 billion and the patent lasts 10 years. Every year, the company has to account $100 million as amortization but it is not taking money out the business. They only paid for it once.

If you look at Google $GOOG in 2018, they had a very high PE ratio. The reason is because they had low net income that year. It is not because the company underperformed but because of a one time big tax payment to bring money back to the US after the new tax laws were passed. The new tax laws gave Berkshire Hathaway $BRK.B tax benefits in 2017. The net income of Berkshire Hathaway varies a lot. In 2016, it was $24 billion, 2017, $45 billion and 2018, $4 billion. What happened in 2018? New accounting rules said that even non-realized capital gain should be accounted as net income or loss. They 'lost money' from Apple $AAPL and other investments last year and all of that is reflected on the net income. In reality, you only lose money when you sell.

A better way to look at a company is to look at free cash flow.

Free cash flow = operating cash flow - capital expenditure

Operating cash flow is all the cash that came in the business from its operations. Capital Expenditure (or Capex) is the amount of money needed to maintain current operations. Warren Buffett, however, prefers owner's earnings over free cash flow. It is about the same thing but it only accounts for capital expenditure needed to maintain the present operations and don't account for growth. For example, the FCF of Parsley Energy $PE is negative but they have a positive owner's earnings because the capital expenditure used to build new oil wells is not accounted for.

Warren Buffett also uses owner's earnings to calculate the intrinsic value of a company. Intrinsic value is total owner's earnings over the lifetime of the company discounted a proper rate.

The only time when I use PE ratio is when looking at whole countries because their faults are cancelled out when you have a large enough sample of stocks. However, even here, the CAPE ratio is better. The best way to analyse a company is look at 10-Q and 10-K forms for several years and to see the real performance of the company, how much cash they are making.

Watch the full video on YouTube and Subscribe for three videos a week:

https://www.youtube.com/watch?v=XC0dRIiSWtM&list=UUPO3uUyoXSaFWG-Ldq1mqEQ

Fitbit-Google deal analysis:

https://ishfaaqpeerally.teachable.com/courses/662813/lectures/12381470

Investing in China article:

https://ishfaaqpeerally.teachable.com/courses/662813/lectures/12745105

You can join my private investing group on Facebook for more:

https://www.facebook.com/groups/IshfaaqInvesting/

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