Online Investing Hacks

Forecast Future Returns

The returns you might achieve using fundamental analysis depend on a company’s earnings growth rate and the price you pay for the stock.

Before you purchase a stock, the challenge is to figure out what sort of return you might earn if you purchase the stock of a company at a specific price. In addition, you might want to compare the potential returns for multiple stocks to see which one best fits your portfolio. After you own a stock, reevaluating its future return from time to time can help you weed unacceptably slow growers from your portfolio. When you use fundamental analysis (see Chapter 4) to evaluate stock, the future earnings growth rate, the potential future P/E ratio, and the current price all play a part in forecasting the future return. With a current price and a potential price a number of years in the future, you can calculate the potential return, often called total return for this situation.

The P/E ratio [Hack #27] represents price divided by earnings. That means that if you have a P/E ratio and a value for earnings, you can calculate a price, which is exactly what you need to forecast future return. Unfortunately, to calculate a future price, you need an estimate of future earnings and an estimate of a future P/E ratio. With estimated this and estimated that, it’s clear that your forecasts for future price and return are only as good as the estimates that you provide. By erring on the conservative side with your earnings and P/E ratio ...