David John MarottaDavid John Marotta is the President of Marotta Wealth Management, a fee-only financial planning and asset management firm in Charlottesville, Virginia. He is an oft-quoted writer and speaker on financial matters and his weekly financial column can be found at www.eMarotta.com
Host: What is a stocks fundamental valuation?
David Marotta: A stock's valuation is usually determined by its P/E ratio and P stands for the price of the stock and E stands for the earnings of a stock. So P divided by E is the P/E ratio. So, if a price stock is 20$ and the dividend that its paying is or the earnings that it's paying is $1 a year then the P/E ratio would be 20 and what that mens is, if you hold the stock for 20 years it will pay for the price of the stock and you will still own the stock. Low P/E stocks are called the Value Stocks and large high P/E stocks are called Growth Stocks. You might ask the question why would you ever invest in a growth Stock? The reason is growth companies are companies that investors expect to continue to grow. So, if you have a Google or an Amazon.
com and its growing at 30% or 40% a year and you expect the growth to continue at 30% or 40% a year, maybe it's not paying very much in earnings because it keeps rolling everything back into the company, but because of the growth rate we are expecting this company to be doubling every couple of years. And so growth stocks are ones that are expected to have a very, very high rate of return. If they continue on that rate of return, it justifies a high P/E ratio. But all it takes is for company that's going very fast to be -- to only grow 25% instead of 35% and suddenly the price adjusts very quickly downward. So, growth stocks are generally a little bit riskier especially in down markets. Overtime value stocks beat growth stocks, value stocks beat growth stocks in down markets and in normal markets. The only time the growth stocks do better is in wild bull markets and strong markets. So for example, in the last half of the 1990s growth stocks were beating value stocks hands down. After 2000 this things started to correct then value stocks have been beating growth stocks.