DAY10: The Davis Double Play explained

Hey, tigers:

Today is our 10th day of "Learn US financial statements".

In this article, I mainly introduce: The Davis Double Play explained.

Many investors run into this problem: The valuation of a company is already high but, regardless of the horizontal to vertical ratio, they still feel it's a good investment.

Should they go ahead and buy the stock of such a company anyway? Or maybe it's a great company, but its stock price has been beaten down; isn't buying an undervalued stock a smart thing to do?

In this article, I'm going to teach you two new facts for trading stocks - the "Davis Double Play" and the "Davis Double killing." After learning about these terms, those questions will be answered.

1. What is a "Davis Double Play" and "Davis Double Killing"?

The Davis Double Play is actually quite simple: from our study of valuation, you learned that Price to Earnings (P/E) = Share Price (Price) / Earnings per share (EPS)When a company has good growth, its earnings per share goes up, and people begin to believe that the company will keep growing at the same rate in the future.

This will push the company's share price higher, and so its PE will also rise.When a company's stock price rises along with its earnings per share and its PE, we call it a Davis Double Play.

And what if a company is not doing well? Conversely, both earnings per share and P/E will go down at the same time. We call this a "Davis Double Killing."

2. Should you buy "expensive" stocks?

Understanding the Davis Double Play and the Davis Double Killing, we can answer the first question: Should you buy "expensive" stocks?

The answer is: you can , if under the right conditions:

a.The extent of an industry's prosperity

If the industry sector of the company is booming, and the industry on the whole has big potential for continued growth, then it's pretty clear that the company will grow.

Dependable growth will bring sustainable development of the industry, and it will also attract the attention of investment institutions. The outlook is even better if the industry has governmental policy support. Good examples of this are the alternative energy and semiconductor industries recently.

b. The industry ranking of the company

After finding an industry with sustainable growth, you need to figure out whether a company is a leader within that industry. Because a leading company generally has a large share of its market, its line of business is relatively stable, it has high technical and brand barriers, and it has a sustainable competitive advantage, it will not be easily beat out by competitors.

c. Excellent financial strength and continuous improvement in earnings

According to what you've learned about financial reports, this criteria is actually a reflection of the company's four main financial capabilities: profitability, potential for growth, operational capability, and solvency; among these, you should focus on ROE.

If its annual report indicates ROE is greater than 15%, it's a good company.

3. Isn't buying an undervalued stock a smart thing to do?

Here I have to mention the valuation trap in the Davis Double Killing. Generally speaking, there are three reasons for stock price declines:

The first is getting the price of a share back to what it's really worth.

The law of the stock market is that prices will always move around their true value.If the price of a quality stock goes up more than the market expects, you'll probably see some short-term profit-taking; in this case, you have to analyze whether there is a problem with the company's earnings.

If there's no problem with earnings and no change in the external environment, that is, if P/E is reduced but earnings per share have not taken a hit, or have even continued to grow, then we might say this counts only as a Davis "Single Killing."

I should note here that if it's only the valuation that gets "Killed," and neither the performance nor the external environment have changed, then this could be a "golden pit", and it's a good time to pick up some stock at a low price.

The second reason is that something has changed in the external environment of the company.

The external environment can include many factors. At the level of individual stocks, we also need to focus on the corresponding industry of a stock.

When the EPS and the P/E of those companies were rapidly falling, forming a Davis Double Killing; it was a race to the bottom, and everyone went there. If you followed, you might have lost all your money.

The third reason is that there is a problem with the company's fundamentals.

If the fundamentals of a company have gotten worse, you'll see it in the company's performance, and eventually in its EPS; and if the Davis Single Kill is triggered by EPS reduction, performance will die, which will have a much bigger effect than just killing the company's share price.After all, no one wants to buy shares in a company that is not performing well and is also expensive.

So, on going "killing" performance often leads to "dead" valuations - the result of a Davis Single Killing becoming a Davis Double Killing;

A common "valuation trap" is when the price goes down because the performance keeps getting worse, so don't buy something just because it's cheap.

So, now you understand why buying cheap is not always a good deal, right?

Okay, let's wrap up this article by reviewing the two new facts for trading stocks: the Davis Double Play and the Davis Double Killing.

A Davis Double Play is an increase in both EPS and in valuation, which creates a "double play" that raises the price of a stock. On the other hand,

if EPS and valuation both drop at the same time, a Davis Double Killing is created, leading to a big drop in share price.

Through these two points, we can judge the price of the company well and obtain high-quality companies at the right time.

Review again: US Stock Financial Statements for Beginners 

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