How do you know when oil is cheap or expensive?
Stocks are so much easier. You could look at Price to Earnings or something like this.
Does anyone have a ratio for oil equivalent to Price to Earnings?
Formula is Value = Oil Price / eE
Where eE is earning Expectation. i.e. what much the buyer is expecting to make from the price.
So if oP/eE <1, it's good to buy.
--------
PE doesn't really tell you much about the value/price of the business. It just give you an idea of what the market is thinking/expecting. And even then, it doesn't really tells much more than a wet finger in the wind.
So if PE is "high"... it indicate that the market is expecting the E in the future to be higher, thus bringing the PE ratio down to a more "reasonable" level. i.e. they're buying it for cheap given what they see the future will be.
But then what is cheap and what is reasonable? We all have our different ideas of it... What is that exepcted E and when do we, the market, know it's been reached? Did anyone send a memo about it?
So if you're to rely on PE ratio, you will still need to know for yourself what your E is. And that's assuming that P is the current market price.
Should price it in two ways...
1. Perpetual bond..... Value = Earning Power/rr.... where rr is your required rate of return, say 10 or 15%p.a. from now into eternity.
You work out, under a few scenario and assumptions, what you reckon the company's earning is likely to be for you as the owner taking over the entire company.
Plug in that EP, divvy it over your rr... that's about how much a reasonable price is.
If Mr. Market is offering lower than that... all else being equal... you strike a deal.
2. Ben Graham's estimation.
Value = EP * [8.5 + 2g]
where g is the expected p.a. growth rate over next decade.
So valuation is pretty simple and straight forward. If you find you're doing too much maths to value the business, you're doing it wrong. Modesty, I know.
The difficult and most challenging part is not the valuation... it's in the understanding of the business.
How to judge its financial position; can the business maintain its market share/position; grow without too much risk; shifting tastes, technological changes etc. etc.
All that is to ensure that you can somewhat get the estimate of its earning power within the ball park.
Then there's the little to no debt.
Some leverage is good and expected. Some debt are good... some will kill the business. At a certain leverage ratio, you're just playing with fire... or rather, the management is playing with fire.
How are you going to have any clue where interest might be over the next decade, or into enternity? You can't... so you avoid those with too much debt.
So while it will eventually boils down to a P/E ratio, or any ratio... what lies behind it must be understood else you're going to get hurt and don't know why.
oh, there's also the asset play.