A Few Thoughts On Trading Attitudes

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A Few Thoughts on Trading Attitudes
Originally Updated: 22-Feb-99
The emotional side of trading is often ignored, yet it is a critical part of being a successful trader. Whereas long term investors can actually forget about their positions at times, traders must stay aware. Today's Stock Brief focuses on the attitudes in the middle of a trade, when you've taken a position but have not closed it yet.
Here are six possible mental attitudes we all might go through after taking a position.
1. I made a mistake.
2. Why isn't this happening?
3. I should have taken a bigger position.
4. It can go even higher.
5. I did this just right.
6. It's better than I expected.
Here are someof Briefing.com's thoughts on each of these.
When you think, I made a mistake, the best thing to do is change your mind, and probably your position, even if it means taking a loss. The best traders on Wall Street are the ones that are capable of taking positions 180 degrees opposed to the ones the held previously, when they change their minds. The alternative, admitting you have made a mistake but waiting until you break even, is a common way to waste a lot of time doing nothing. The better traders take the loss as soon as they admit it is a mistake, and move on.
Why isn't this happening? This is a tough one, because clearly your understanding was different from reality. For investors, as long as you still believe in a situation, you can wait. But for traders, who are hoping for something quickly, it becomes important to move on from the "why isn't this happening" thought to either "did I make a mistake?" or "it is going to happen." Waiting in the nebulous "why" attitude is frustrating, but it also means you don't have an understanding of what is going on. Even if your understanding later turns out to be wrong, it is better to think you know what's driving a stock than to be stuck being puzzled. Presumably, you had an understanding when you took the position, but now you aren't sure. We realize it is hard to go back to a solid "it is going to happen" once you admit doubt, but if you can't do it, its usually better, as a trader, to move on.
I should have taken a bigger position. We all know this one, you make the first part of a trade, and suddenly it looks like a really good move. Any caution you had felt prior to the investment now seems trivial, maybe even "wimpy." Nevertheless, you shouldn't be hard on yourself. It's only greed coming out. Giving in to the temptation and plunking down an even greater position isn't always wise. Sometimes the second position, made at higher levels, doesn't work out, or even wipes out the profits from the first.
It can go even higher. Once you have paper profits, the realization that you might make even more is a heck of a temptation. It's common to us all. The main fear is that, if you sell, you will be leaving some money on the table. But sometimes, you think this at the top. If you've ever postponed closing a position thinking it would just get bigger, and then lose the paper profits, you know what we are talking about. Better to leave some on the table, than to not take any home. This is what J.P. Morgan meant when he said, "I never knew anyone who went broke taking a profit."
I did this just right. Admit it, this just isn't human nature. It's the rare person who feels that their moves were executed exactly as they should be. Unlike ballet or Olympic diving, there is no "10.0" score for investing. Despite what people brag about, at cocktail parties or in chat rooms, no one gets in with a major position just before the big move, then gets out right at the top, and does it all the time. Thinking that there are people who do this, the Michael Jordans of trading, is a mistake. Even the best traders can't get the maximum out of a position without a good dose of luck.
It's better than I expected. This is another one that's rare, because let's face it, everyone's wildest dreams are usually beyond what actually happens. Furthermore, when something really good does happen, the first thought is usually "I should have taken a bigger position!" Nevertheless, sometimes things work out really well, and you are able to close a position with substantially larger profits than you planned. If this happens, and you are actually able to think, "this worked better than I planned" give yourself some credit for restraining greed.
Of all these thoughts, "I should have taken a bigger position" is actually the best of the possible attitudes, and it is the one we hope all Briefing.com traders wind up feeling. It means you made money, and probably, you did it without being reckless. That's the best of both worlds.
Robert V. Green

Understanding Price/Earnings Ratios
Originally Updated: 24-Aug-99
Of all the fundamental statistics available for comparing stocks, the Price/Earnings ratio is the single most widely used. Although all of the other ratios involving a stock's price -- Price/Sales, PE/Growth, Price/Book, Price/Cash Flow -- have value, the P/E ratio is the most well known, most often quoted when only one statistic is given, and serves as an instant reading on the value of a stock.
What Is It?
At first glance, the Price/Earnings ratio seems quite simple. It is calculated, using per share data, as:
Unfortunately, the P/E statistic is frequently used without clearly defining exactly what is being discussed. Although the math is easy, and the price is usually well-defined, there are options for determining the earnings number, and this is where the most confusion about P/Es occurs.
Types of P/Es
When you see that a stock has "a P/E of 22.0" the first thing you must do is determine what kind of P/E this is. This usually means determining what kind of earnings number is being used. There are several kinds of P/Es:
 Trailing P/E: The earnings are the most recently reported quarter, plus the previous three reported quarters. The abbreviation TTM is often used to indicate Trailing Twelve Months. However, it really means trailing four quarters of reported numbers.
 Forward P/E: The earnings number is the total of estimates for the current unreported quarter and estimates for the following three quarters.
 Fiscal Year P/E: Often you will see P/E as calculated on a particular fiscal year for the company. This may be in a chart or table with P/E's for several future fiscal years shown. When this is done, the current fiscal year may have some actual quarters and some quarters with projections. The future fiscal years are all estimated, of course. For example, in January 2001, FY02 P/E would refer to today's price divided by the total earnings estimated for fiscal year 2002. FY01 P/E might include some actual quarters and some estimated. If the current fiscal year is not complete, the numbers are usually listed as estimates, even if there is only one quarter unreported.
There are other variations as well. For example, Value Line uses a blended P/E ratio, which they define as the most recent two actual quarters added to the estimates for the upcoming two quarters. Occasionally, you will see the current quarter's estimates combined with the three trailing quarters.
In all of these variations, however, the price used is today's price, or at least, the price on or around the time of analysis. Rarely is a future (projected) price used, and a historical price is never used. When you see a reference such as "Microsoft never had a P/E higher than 27 in the 80's" the price being referred to is always the price at that time. Generally, in historical reflections, the earnings will be trailing earnings. Occasionally you will see a comparison of today's Forward P/Es with Forward P/Es from the past, but the historical Forward P/E calculations will likely use the actual forward earnings, not the estimates from those times.
Earnings Variations
It is obvious, of course, that estimated earnings will vary by source. However, even actual earnings may vary by source, due to calculation methods. While the total earnings of the company is always known, in deriving the per-share earnings, there are two factors to consider: 1) basic versus diluted shares; and, 2) including or excluding extraordinary charges.
Basic earnings are calculated by taking the total reported earnings of the company and dividing by the number of shares actually issued currently. Fully diluted earnings are calculated by taking the total reported earnings and dividing by the total of the following: 1) all shares issued; 2) plus all shares subject to options; 2) plus all shares subject to warrants;3) plus all shares subject to convertible bonds. In short, "fully diluted" calculations postulate what would happen if everyone who has a right to a share, exercised that right today. In many cases, for example options, the holder cannot actually exercise that right today. However, since many companies continually issue new options and these are converted over time, fully diluted earnings calculations help account for that future dilution.
Basic earnings per share numbers will be higher than fully diluted earnings per-share numbers when earnings are positive. But when a company is losing money, the diluted EPS will be higher as the higher share-count will produce a smaller per share loss. P/Es using basic earnings numbers will therefore be lower than P/Es using fully diluted earnings numbers when a company is profitable (when a company is losing money, a P/E cannot be calculated).
The other calculation affecting earnings is extraordinary charges. Extraordinary charges are expenses that companies classify as non-recurring, and are treated as a separate line item on financial reports. These may be costs associated with a layoff or merger, or other one-time event. Generally, most analysts exclude extraordinary charges from earnings calculations. (In fact, Wall Street routinely ignores extraordinary charges altogether even though the expense is real.) If you are making your own P/E calculations from annual reports or from screening databases, you should probably make your calculations using the earnings line which excludes extraordinary charges.
What Good is It?
Quite simply, the P/E ratio gives you a quick comparison for determining whether a stock is "cheap" or "expensive." Stocks with low P/Es are "cheaper" than stocks with high P/Es. If the stocks are in the same industry, have the same annual earnings, but have different P/Es, the stock with the lower P/E is cheaper. That doesn't mean it is a better buy, as it may have a lower projected growth rate, or some other issue. On the other hand, it might just be cheaper. The P/E ratio is simply a good place to start when making comparisons between stocks.
Comparing P/Es
With all the variations in P/Es, you must make sure you are comparing apples to apples. In any published report, Briefing.com will always identify when a variation in the P/E is being discussed. Briefing.com's Company Reports use Trailing P/Es. All companies now use diluted share-counts when calculated P/Es.
During earnings reporting season, you also have to make sure that both stocks you are looking at have the same reporting status. With Trailing P/Es, as soon as a stock reports, the new quarter is substituted for the oldest quarter's earnings. If the second stock has not yet reported, its TTM P/E will not reflect the same time period and you should take this into account.
The biggest problem, however, is comparing P/E numbers for stocks when using two different sources. When comparing an analysis from one source with an analysis from another source, you need to check the P/E calculation methods before comparing P/Es. Comparing one stock's Trailing P/E with another's Forward P/E will be misleading.
In researching or analyzing stocks, Briefing frequently uses forward P/E's, or fiscal year P/Es, using estimated earnings for the coming year. These are always clearly identified as such. In no case will Briefing mix different P/E calculations for different stocks in an analysis without clearly identifying which P/Es are being used.
Which method is best? Unfortunately, no single method is clearly better than another. Each is useful. Trailing P/Es are solid numbers. Forward P/Es can be misleading, if estimates turn out to be wrong. However, Forward P/E's are helpful, especially when paired with the PE/Growth ratio, as this gives a picture of how expensive the stock is relative to its expected future growth. And the future is what the stock market is all about.
Robert V. Green

Understanding Volume
Originally Updated: 16-Sep-99
Volume is an underappreciated statistic.
When people ask how the market did today, they rarely ask about volume. Yet volume tells as much about market strength as price movements in the Dow Jones Industrial Average or the Standard & Poor's 500 Index. Volume indicates how meaningful a market movement is.
Large percentage increases accompanied by large volumes are a solid indication of market strength. In contrast, large percentage increases accompanied by small volumes are less likely to indicate a market direction.
Market volume is a relative term and needs to be compared to the average daily volume of the index or stock in question. This number is sometimes difficult to obtain. For example, average daily volume of the Dow Jones Industrial Average is rarely publicized. Nevertheless it is useful to know the number.
Volume on Individual Stocks
Average daily volume for an individual stock is also a difficult number to obtain sometimes, however it is extremely helpful to have at least a "feel" for the average volume. This will help you make a judgement on how meaningful a large percentage movement in the stock is.
A large percentage price increase accompanied by a higher than average volume is a strong indicator of future price movements. A large percentage price movement accompanied by lower than average volume is a very weak indicator of higher prices, and is, in fact, an indicator that a correction in prices is possible.
Similarly, a large downward price movement accompanied by higher than average volume is a strong indicator that the stock will continue to move downward.
Most intriguing of all, however, is higher than average volume accompanied by no price movement. This generally indicates something happening behind the scenes, such as a news event, or rumor, but the buying is not accompanied by market orders. Determining what is happening when accumulation of this kind occurs can be difficult, but sometimes rewarding.
Thin Volume
On extremely thinly traded stocks, volume is an important indicator of value. For example, there are some investors whose holdings are larger than the average daily volume of a stock. If this is the case, you simply cannot compute your holdings value by multiplying the price times your shares.
Why? Because if you unload it all at one time, you just aren't likely to get the current price. When your volume gets close to the daily volume size, your own actions will more than likely affect the price.
In any event, watching volume as well as price is always helpful.
Robert V. Green

P/E vs P/S
Originally Updated: 29-Mar-00
For much of the late 1990s, the Price/Sales ratio was more important than the Price/Earnings ratio. And therefore, you needed to know the price/sales ratio of every stock you owned, by heart. Though the market is not always willing to focus on sales over earnings, it still happens when new companies have not yet achieved profitability. When that's the case, the P/S ratio is the best single indicator of what the market expects from the stock.
The End of Price/Earnings
Every now and then, we get an email with a question like this:
How can anyone justify paying a P/E of 400 for XYZ?
It is a valid question. But the real answer is that, for most stocks with incredibly high price/earnings ratios (or no P/E ratios), no one is really looking at earnings.
They are looking at the promise of future earnings. And the promise of future earnings comes from high revenue growth curves, with a scalable business model that produces higher earnings in the future.
So any company with a proven high revenue growth curve, and a scalable business model, can be expected to have strong future earnings. Therefore, paying more, on a price/earnings ratio basis, is worth it.
That is how stocks get P/Es of 400. The current P/E ratio, however, is meaningless in this line of thinking.
It is far more important to gauge the stock's valuation by the price/sales ratio, because all of the assumptions of future earnings are based on the revenue projection, not the earnings history.
The price/sales ratio is:
Market Capitalization /Trailing Twelve Month Sales
Internet Stocks Started It
Internet stocks first put the price/earnings ratio on the back burner. After all, most IPO-ed long before they showed profits. Many never did.
But, with the public eager to help finance the future of the internet, profitability wasn't important. Many are willing to invest in a company on the promise of future earnings.
Anyone who invested in America Online in 1995, or Yahoo in 1996, has been rewarded for accepting the promise of future earnings, rather than insisting on current earnings.
The appetite for "private venture investing" was so large, that even a company like Sirius Satellite Radio (SIRI) was able to go public without revenues, much less earnings. For Sirius, you couldn't even calculate the price/sales ratio. It was a pure venture investment.
But for companies with existing revenue curves, the price/sales ratio is a measure of what the market expects, and is based on the existing revenue history.
Price/Sales Implies Growth
A high price/sales ratio implies a high future revenue growth curve.
Most stocks with high price/sales ratios have at least a few quarters of demonstrated high revenue growth. Based on that proven revenue growth curve, the future revenue growth curve can be projected.
And the higher the future revenue growth curve is, the higher the price/sales ratio that investors are willing to pay.
Price/Sales Ranges
Mature companies of great size ($1 billion or more in sales), that have revenue growth prospects of 5% or so are currently awarded price/sales ratios of between 2 and 4. Examples in 2000 were Bell Atlantic or IBM; large, technology stocks, with growth prospects in the 5-10% range.
Large technology stocks with larger revenue growth prospects can achieve larger price/sales ratios. In 2000, Microsoft, with a 25-30% revenue growth projection, had a price/sales ratio of 23. Cisco had a one-year growth rate of 50%, and a price/sales ratio of 30.
Smaller technology stocks with higher revenue growth prospects can get higher price/sales ratios. Metromedia Fiber Network, with a one-year growth trend of 200%, had a price/sales ratio of 240. Cree, with a one-year growth rate of 60%, had a price/sales ratio around 70.
Monitoring Price/Sales
So your stock has a high price/sales ratio.
What do you do?
If you are a long term investor, you need to make sure that the price/sales ratio is justified. First, you should examine whether your price/sales ratio is in line with other stocks in the same industry. This can be done by checking the 3 year and 1 year revenue growth curve for companies of a comparable size. (These rates are available in Briefing.com's Company Reports pages.)
Secondly, because a high price/sales ratio implies strong revenue growth, you need to make sure that revenue growth is actually continuing to grow.
This is done by calculating not just the revenue growth percentage increases, but the rate of revenue growth.
A decline in the rate of revenue growth is normal as revenue increases. After all, it is harder to grow, the larger you get. But there are many small stocks with increasing revenue growth rates, currently, which implies even higher future revenues. When these stock show a decline in the rate of revenue growth, the stock can get creamed, as the price/sales ratio is knocked down to a lower level.
Price/Sales As a Measure of Risk
Stocks with high price/sales ratios have more risk associated with them.
The reason is simple. The assumption of higher growth, on which the high price/sales ratio is based, is dependent on higher growth actually happening. When it doesn't, the high price/sales valuation comes down, usually significantly, and the stock price falls, often dramatically.
To fully judge how much risk is in your stock, you need to make a comparison of how your stock compares to other stocks in the same industry, with the same revenue expectations.
A Common Misunderstanding
We noted above that a high price/sales ratio implied a high expectation of revenue growth.
Some readers might infer from that statement that the message was "the higher the Price/Sales ratio, the better," since high revenue growth is a good thing.
Nothing could be further from the truth.
In fact, because a high price/sales ratio implies a high revenue growth curve, any failure to live up to that expectation is severely punished by a drop in valuation.
Anyone investing in a stock with a high price/sales ratio needs to understand that the rate of revenue growth is more important than revenue growth. An unexpected slowdown in the rate of growth will cause a sharp drop in the stock, even if the actual growth is positive.
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