One of the most fundamental ways to value and compare stocks is with the PE, or Price-to-Earnings,
Ratio.
If you plan to do anything in the investing world - even if that’s just spectating or
watching CNBC - you’re gonna feel lost if you don’t understand this ratio.
Luckily it’s really easy!
Everything you need to know… coming up!
Hey there!
It’s great to see you again.
On this channel, it’s my goal to help you build your rapidly-growing, highly-diversified
net worth, one video at a time.
And understanding investment basics, like a company’s PE Ratio, is important for your
long-term investment success.
Because a company’s share price does not in any way reflect its value, it’s not helpful
at all in our effort to value and compare companies.
Apple, despite its $150 share price, is still worth $150B more than Amazon.
The Price-to-Earnings Ratio provides us a simple way to assess the value we’re actually
getting when we purchase one of those shares.
.It measures how much you’re paying for every dollar of a earnings
You can use it to initially gauge how similar companies in similar industry sectors compare
to each other.
It’s made up of two variables: a company stock’s Price Per Share and a company’s
Earnings Per Share, or EPS.
Price Per Share is easy to see.
It’s simply the share price at which a company’s stock is currently trading.
EPS, on the other hand, requires a little calculation.
It’s the company’s profit divided by the number of shares outstanding.
So it’s the amount of profit that could be attributed to each of those individual
shares that you’re considering purchasing.
Kind of like you would do with any investment - I’m going to buy this house for $100,000
that is renting out for $5,000 per year - that’s your ...Earnings Per House.
There is obviously a lot more that goes into that, but when you’re considering an investment
you want to know how much its producing.
And Earnings Per Share gives us a quick and easy (albeit incomplete) glimpse at this.
Thus when you’re comparing the Price of a share to the Earnings per share - in other
words, when you evaluate the PE Ratio - you learn how much investors are willing to pay
for every dollar of earnings, or how much you would have to pay for each dollar of earnings.
For example, at the time of this recording, Google (or Alphabet’s) shares are trading
around $1,000 per share.
Its Net Income over the last 12 months was just under $17B and there are about 700MM
total shares outstanding.
That means they earned around $24 per share ($17B/700MM shares).
With that information, investors have been willing to pay the current $1,000 price per
share.
Thus, they’re willing to pay around $42 (Price/EPS or $1,000/$24) for every dollar
of earnings, or you could say, Google has a PE Ratio of 42.
You can compare that to the fact that investors are only willing to pay around $16 for every
dollar of earnings from Apple, or Apple’s PE Ratio is 16.
Facebook’s PE Ratio is around 100.
Netflix’s is a little over 200.
Amazon’s over 250.
You might also want to use this number to compare a company to its industry or sector.
The technology sector, for example, right now has an average PE Ratio of just under
43.
Or you could look at the market as a whole.
For example, you could use the Standard & Poor’s 500 as a proxy for large United States companies.
It’s PE Ratio right now is around 25.
From these numbers, it would appear, investors are expecting much more future bottom line
growth from Amazon than Apple.
If you have reason to disagree, you have reason to believe Apple will grow just as much or
more than its competitors, perhaps you have the start of an investment thesis that Apple
is undervalued, and thus would make a good investment for your dollars.
Or, on the other side, maybe you think investors are overestimating Amazon’s future.
And you have a case for its stock being overvalued.
Neither one of those reflects my personal opinion, they should just serve as an example
of how PE can offer a down and dirty, side-by-side industry comparison.
And how it could help steer the direction of your research.
So, depending on how you compare it, a company could appear over-, under-, or appropriately
valued based exclusively on its Price-to-Earnings Ratio.
But obviously, there is so much more to a company than its earnings over the last 12
months…
For example, as I just mentioned, this calculation in no way accounts for expected future growth,
which is likely the reason that Amazon consistently maintains a high ratio.
On top of that, it also doesn’t accurately account for a company’s current financial
position (considering important factors, like debt and cash reserves).
Many investors prefer to use a metric known as Enterprise Value to account for that as
well.
Also, consider the fact that net income does not accurately account for a company’s current
operating performance, like the metrics EBIT or EBITDA might.
If you missed either of the videos I did explaining those subjects, be sure to check them out
through the links in the description right after this.
Despite its shortcomings, you’ll still hear PE Ratios referenced all the time in the investing
world.
Its quick and easy calculation offers a convenient metric for initial comparison and cause for
further research and analysis, which is a great way to use it.
But you should stop there.
Definitely, do not use a company’s PE Ratio as the primary driver for you investment idea.
Try to figure out what else is going on with the company.
Is there a reason for any discrepancies you may have discovered?
Next time we’ll cover more comprehensive company comparison ratios.
However you chose to use them, I hope you find this information helpful on your path
to building your rapidly-growing, highly-diversified net worth.
I really do hope so, because that’s my goal with this channel.
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Take care.