No new tech stock picks today, my 7 current trades are all filled up. Instead, I wanted to tackle one of the questions that I get over and over. Here is one example but there are several more:

“How about P/E ratio? I was always under the impression 18 was the limit. Then my broker told me not for utility stock it is lower – 14. Another article recently “Don’t Be Afriad of High P/E’s”

As I’ve said several times already, P/E ratio is one of the things that I pay the most attention to when I invest in stocks. It’s not a perfect metric by any means. There are cases where the number doesn’t work such as companies that are losing money or if a company had non-recurring items such as AOL’s patent sale which can “screw up” the earnings and thus the P/E ratio. That being said, it’s probably what I use the most when I feel like the number is reliable. Why? Because it gives me a comparable metric to use between stocks.

There Is No “Good” P/E

I do understand why some investors stay away from high P/E ratios such as Amazon. Those companies typically carry more risk. There is a reason though why investors are willing to pay a higher P/E.

It’s All About Growth

I typically look at growth in sales/revenues and earnings. The reason of course is that you typically will pay more for a company that can grow faster.  Why? Let’s imagine a company named Microsoft (MSFT) which currently trades at a P/E of 18 and Google which trades at a P/E of 26. To make things easier, let’s imagine they both made $1 of earnings.

So Microsoft would be trading at $18 and Google at $26. Which one would you prefer buying? Clearly, Microsoft is cheaper to buy for the same earnings. But what if Microsoft is growing at 10% while Google is growing at 20%… ?

One year from now. Microsoft would be making $1.10 and Google $1.20.  Suddenly, the “forward P/E” for Microsoft would be 16.4 and Google 21.7.. much closer right? If you keep the same growth for 3 more years and they’d be trading at basically the same “forward P/E”. So if I anticipate Google can keep up that growth advantage for 4 years, I’ll go for Google without a doubt.

Every time I do such a trade, I try to look at past growth and make projections as well as evaluate the probability that growth will keep up, accelerate or decline.

There Is No Answer

I could not tell you if I prefer high P/E ratio stocks or lower ones. It all depends on the level of growth I expect in the future. I’d recommend that you do the same. Many try to use the PEG ratio or P/E ratio to growth which can work. I prefer to do my own analysis because the growth used in the PEG ratio is also very easy to debate.

Do You Use The P/E Ratio? If so, how do you compare different P/E ratios?

A fellow blogger emailed me asking for more details about my “upside” and “downside” analysis. I often discuss those 2 factors when I make stock picks and they are a critical part of my stock analysis. It’s not as easy to explain how I use them compared to other factors such as a P/E ratio for example. I’ll still give it a try today. Basically, I feel like every stock has a profile that can be defined among other things as upside and downside.

In An Ideal World…

How do you balance upside and downside when you try to value stocks?

In my quest to become financially independent as quickly as possible, I’ve been looking into many different types of passive income. Why? Because I’m trying to make sure that I depend as little as possible on having a full time job, on promises such as my government pensions, etc. I’m far from alone and I’m guessing that many of you are trying to do the exact same thing.

One dangerous thing to do though is simply trying to categorize every flow into 2 categories: passive or not.

It’s Not Black And White

Obviously, working a full time job where I get paid for every hour that I work is 0% passive right? The opposite might be having an annuity or pension that is paying me money every month, no matter what happens. That would be considered 100% passive.

I would argue that most income flows are somewhere in between. Investment cash flows (such as dividends) are very close to being 100% passive but they do require some work in re-balancing and monitoring the position.

My online company that generates a decent amount of money every month is also quite passive. But if stopped looking at my websites, writing on this blog, paying writers, renewing my domain names, etc. The income that is generated would gradually decrease and eventually become a fraction of what it is today.

I’ve also discussed ideas such as owning real estate which I plan on doing in the future. Again, I know several owners that rent out condos or houses but take little to no care of their buildings. The income remains but over time if renovations are not taken care of, good tenants found, etc.. that income can also dwindle.

So Does Passive Income Actually Exist?

I would argue that we should strive to make our income as “passive as possible”. It will likely never be completely hands off but if over time I’m able to:

-Have more employees in my web business and focus on things I enjoy that require less time.
-Have a fairly automated or simple process to manage my investments (or in some cases hire someone to do it)
-Have someone that can do most of the work on my buildings, collect rents, etc

I think it’s safe to say that my goal is not only to increase my passive income and make it as diversified as possible but also to try to make that income as passive as possible over the years.

There are some expressions used that I just don’t get. Maybe it’s me that’s way off, or maybe those that mention it don’t know what they’re talking about. Today, I mentioned one of those in a newsletter that I sent out and wanted to get your thoughts on another one. I’ve seen this one mentioned several times on blogs, but even in discussions with friends. Before giving you my opinion, in case you don’t know, dividend yield on cost is generally described as:

-the annual dividend paid out by a company / average cost of that position

In some cases, it could be perceived as useful by some dividend-focused investors. If you buy a stock for $50 that pays a $1.50 dividend (3% yield) and that over 5-10 years that dividend increases to $3/year, some would say that the yield on cost is now 6%. In a way, it does represent the fact that the investment probably did very well. The stock increased its dividend by 100% and its price also likely increase significantly. If the yield remains at 3%, the stock would now be worth 100% more.

So yes, I could see how the average cost would be “useful” in such a context.

But tools to analyze stocks should work most if not all of the time. There are countless examples where this does not work as well. Take that same stock described earlier and imagine that the company is struggling. Yes it did increase the dividend over the years but it is also paying out more than what it is making (payout ratio > 100%). In such a scenario, the stock price would have decreased significantly.

So yes, both stocks would have a 6% dividend yield on cost… but they can’t be compared.

Average Cost Is (Mostly) Irrelevant

There is one big reason why I look at my average cost; taxes. When trading in a taxable account, average cost does make a difference in trying to determine if a position should be closed, especially near year-end.

But otherwise? Not in a million years. If I purchased a dividend stock 10 years ago in a taxable account and it pays out a 3% dividend yield, I would evaluate it in the same way as any other stock no matter if I’m up 10% or down 50% on the stock, it’s irrelevant. Yes, from a psychology standpoint, it’s difficult to sell a stock and make a loss “official”, we always hope the trade will revert. But in most cases, it’s a big mistake to hold on to a stock for those reasons.

Do you believe in using yield on cost or average cost in general? If so, how do you use it?

There a couple of bigger projects that I’m working on following feedback from all of you. One of them is an ebook that will basically explain my thoughts on investing, retirement planning, etc. I do plan on having it released before the summer, if you’d like to find out first when I do, please join my mailing list:

Here is one excerpt from the ebook:

Thing have changed dramatically in the past 10-20 years but only in the fact that some of us will struggle to retire but there is also an increasingly big group of people that retire in their thirties or forties and sometimes even earlier. Yes, of course they do more than stand around and sit by the beach.  That is because being retired has taken a different meaning in recent years.

It’s All About Being Financially Independent

Just look around the internet and you’ll see plenty of “retired people” that are working more than I do. The difference? In theory they could stop working tomorrow and take several months, years or even decades to simply enjoy life.  It’s unlikely they would ever do that. As much as we like to think that the best life is doing absolutely nothing, most of us are smart enough to know that it’s only fun for so much time.

That being said, being financially independent makes a world of difference. Why? Because:

-going to work feels so much better when you know that you “could” leave tomorrow

-avoiding the stress with family and friends of worrying about expenses, paying your bills, etc

-it doesn’t take money to make money..but it sure helps a ton, it gives you more possibilities, etc

-makes it easier to go for your dreams when you know that if ever it doesn’t work out, you’ll be fine

What Does It Mean To Be Financially Independent?

This is certainly something that would be incredibly different from one person to another. Some would say they need $30K per year, others would say they need to be worth $1M, $2M or some other “magic” number. I’m making my mission very public by publishing my goals and progress every month. What does it mean for me? I’ll try to put it in a simple way:

-Being able to generate enough passive income to be able to pay my bills

-Have that income increase yearly by the inflation rate or more

-Being very diversified: knowing that no one event, government policy change or other could affect me significantly

It’s A Lot Trickier In The 21st Century

I’m not saying that my parents had it easy (ok maybe in a way I am) but I think it’s fair to say that being financially independent these days is a major challenge. I will go over some of the main challenges but also how I am making this work on my end. To give you a few hints, some of the major changes are:

-company pensions slowly disappearing or being adjusted

-governments that are financially in trouble and breaking promises

-interest rates decreasing to 0% (or very close to it) which has forced changes in the “traditional” retirement

What are your thoughts on retirement? Do you feel like retiring now is the same as it was 20 years ago?