Looking just at earnings would not guarantee you the best returns.
One of the most important factors to consider in your investing is how cheap or rich current markets are.
After rallying for a decade after the fall of Lehman Brothers, stock markets in the US are expensive.
However, we continue to see value in other parts of the world.
Measure of Richness and Cheapness
Warren Buffett said it best when he advised people to "Be fearful when others are greedy and greedy when others are fearful." It is always best to invest during a market downturn when everybody else is panicking. In order to have the courage to do so, one must have a framework for what constitutes value.
Warren Buffett and many value investors use cash flow as a significant sign-post of value. The logic makes sense, if a business adds value, it would generate sufficient free cash flow. The issue then is how much an investor would need to pay to own this business. Thus the Price to Earnings ratio becomes a key metric. As earnings can be manipulated, value investors also look closely at other measures of cash like "Cash from Operations", "Free Cash Flow" and Price/Book Value.
In the last 10 years, the Nasdaq has outperformed the S&P500. This is despite many companies on the Nasdaq being loss making or having negative cash flow. This is because many investors have given credit to the high growth companies on the Nasdaq, believing that eventually they would be profitable. Thus, they have out-performed value investors.
In order to value the growth potential of a company, investors look at the price they would pay given the growth rate of the company. The Price/Earnings Growth or PEG ratio becomes a key metric.
While it is of course the best to invest when securities are cheap, it's not always possible to do so because these opportunities are fairly rare. If we cannot enter investments at the cheapest price, we should ensure that we are comfortable with the long-term prospects of the business.
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