Good morning! When I first started investing, an old friend taught me that you have to ask one key question before relying on a PE multiple to value any company - "are earnings sustainable?". If the answer to that question is yes, then you have to try to accurately guess what sort of upward trend in earnings is the most likely to happen, and value the company accordingly. The faster, and more certain the earnings growth, then the higher the PER that can be justified, within reason.

The good news is that, at this stage of the economic cycle, most people (including brokers making forecasts) tend to under-estimate the effect of operational gearing, and hence companies tend to out-perform against forecasts in an economic recovery.

That means two things - that if you spot a good company with decent management on a reasonable rating, then you might well get a pleasant surprise on results day. The opposite also being true - that if you over-pay for a company that does not deliver strong profits growth, then you'll get a nasty shock on results day as the share price will open a lot lower. In a bull market investors often over-pay for growth stocks, and that is very much the case at present - I can foresee many of today's extremely expensive growth stocks leaving investors heavily out of pocket once reality dawns on people. Momentum doesn't carry on forever. However, the odd one will do very well.

So with the market for smaller caps generally quite expensive at the moment, there are going to be a lot of banana skins around this year, as those hefty PERs come down to earth with a bump for companies that fail to deliver strong earnings growth. So you have to be very, very sure that a company is indeed going to perform well, before paying an expensive earnings multiple for the shares.

 

 

 

Fairpoint (LON:FRP)

At the opposite end of the valuation spectrum is  Fairpoint (LON:FRP) which is a debt management company, helping consumers recover from severe over-indebtedness. They seem to operate ethically, from what I can ascertain.

I listened in on a conference call with management last year, and asked a few questions, and they sounded competent.

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