how can you tell if a stock is cheap or expensive a lot of new investors
go immediately to the share price this is a mistake that i made but let me ask you a question
today one share of autozone is trading for six hundred and fifty dollars conversely one share of
coca-cola is trading for about fifty three dollars which of these two stocks is expensive well the
actual answer is not enough information the share price doesn't tell you enough to know whether or
not a company is trading at an expensive price or a cheap price you have to go one step beyond that
one of the valuation metrics that investors can use is something called the price to earnings
ratio and the price to earnings ratio for autozone right now is about 17. by comparison
coca-cola the 53 stock has a price-to-earning ratio of 28. according to that metric
autozone is actually the cheaper stock when compared to coca-cola confused will
help to break this down for you my name is Brian Feroldi and my name is Brian Stoffel
thanks to quartr for sponsoring today's video
brian what is the p e ratio so the p e ratio is a very simple mathematical equation
all you do is you take the share price so about 53 dollars per share that you had with coca-cola
and then you divide that number by the amount of earnings or profit a company made per share and
when you divide the price the p by the earnings per share the e you get the price to earnings or
p e ratio and in general with p e ratios the lower the number the cheaper that company is
and the higher the number the more expensive that number is and it can be a quick and dirty way to
figure out how highly valued a company is or not let's go through a very simple example to showcase
the p e ratio pretend that i own a lemonade stand and that lemonade stand over the course of a year
sold ten thousand dollars worth of lemonade to produce that ten thousand dollars in sales
we had to spend nine thousand dollars on lemons ice taxes insurance depreciation everything
that leaves us with a profit of one thousand dollars per share and then i asked brian say brian
i'm interested in selling this lemonade stand how much would you be willing to pay me to buy it
i'll tell you what i will pay you one thousand dollars for this stand one thousand dollars okay
i agree to that price we exchange we exchange the one thousand dollars and brian gets the business
well let's analyze that deal well first off the price of that deal was one thousand dollars
and the earnings of that deal were one thousand dollars in profits so what is the price to
earnings ratio of this very simple deal the answer is one now is that a good price for me or is that
a good price for brian well let's do another very simple math calculation called return on
investment and this calculation is just taking the profit that you earn from an investment and divide
it by its purchase price so brian is expected to earn a thousand dollars in profit from that
lemonade stand and he only paid a thousand dollars to acquire it that's a return on investment of 100
per year that's a very good return clearly brian got an amazing deal by buying the lemonade stand
for a thousand dollars conversely i got a horrible deal as the seller so one thousand dollars is
clearly too low make me another offer all right i'm a good friend i'm going to offer you a hundred
thousand dollars for your lemonade stand all right a hundred thousand dollars is that a good price
well let's do that same calculation well the price to earnings ratio of this deal is one hundred
a hundred thousand dollar purchase price divided by one thousand dollars in profits at a one
hundred thousand dollar purchase price what would brian's return on investment be well it would be
one thousand dollars in profits divided by that one hundred thousand dollar purchase price that's
a one percent return on investment is that a good deal well why would brian go through the effort of
buying and operating a lemonade stand well he could take that money invest it in bonds and get
a higher than one percent return on investment so that is actually a horrible return for brian
the buyer but it is a great deal for me the seller all right brian let's meet in the middle let's
say that a fair return for you is 10 per year so what kind of purchase price would that be for us
i'm not good at math but i can figure out that that would mean about ten thousand dollars
a ten thousand dollar purchase price for the business would give brian a ten percent return on
his investment which is a fair return in investing speak we would say that the deal was priced at
10 times earnings or the p e ratio of this deal was 10. notice that the p e ratio is the inverse
of the return on investment for the buyer all right that was a very simple example let's make
things slightly more complicated instead of we getting a thousand dollars in profits every year
from this business let's pretend that the business is growing about twenty percent per year so in the
first year we get a thousand dollars in profits in the second year twelve hundred in the third year
fourteen hundred and forty fourth year set one thousand seven hundred twenty eight etcetera etc
now let's do the price to earnings analysis in year one after year one well if we look
at backwards at what the company just did for us that's called using the trailing price to earnings
ratio and the trailing price earnings ratio of the deal was 10. we purchased it for 10 000
it earned us a thousand dollars in profit that's a p e ratio of 10.
however we can also use what's called the forward p e ratio and that's looking one year ahead about
what the assumed profits are if the company is going to grow 20 on that basis we would take the
price 10 000 divided by the earnings the expected earnings of twelve hundred dollars and that gives
us a forward p e ratio of eight point three notice that's lower than the trailing pe ratio which
indicates that the business is expected to grow this video is sponsored by quarter with quarter
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quarter thanks quarter for sponsoring the video all right the p e ratio is a wonderfully useful
tool for figuring out the valuation of a company but i can tell you that i misused it plenty of
times in my past because i didn't know how to use it effectively more specifically i didn't
understand a company's growth cycle and when you should and should not use the p e ratio
so let's go through a quick example that shows a company's revenue and profits as it grows in the
first stage of a business development it's in the r d stage it's often producing no revenue
no profits and it has nothing but expenses after it goes to the r d stage it finally launches the
product in this stage it costs a lot of money to run the business but it's not yet bringing in
enough revenue to cover its cost it's very common for companies in this stage to be losing money
however as the company continues to grow it eventually reaches a break even stage and at
that point its profits become zero that's actually a really good thing and a positive sign for the
company after which some companies in this stage can experience hyper growth when their revenue
growth accelerates and importantly their profit growth really accelerates eventually their hyper
growth stage ends and they reach a steady state growth rate or a maturity rate at this stage the
company is fully optimized for profits and revenue and profit growth became far more normalized
a company can be in this stage for years or even decades but eventually the company is going to
reach the decline stage where it goes out of business eventually one mistake that i made
as an investor was i tried to use the p e ratio in this stage here when a company was in hyper
growth mode i looked at its p e ratio to figure out if it was expensive or cheap and actually
that was a huge mistake one of the reasons was it was a huge mistake was because of a term called
operating leverage this is when a company's profits can grow at a far faster rate than
its revenue as the company continues to scale so how can we figure out what valuation metric we
should use in each of these stages well here's a rough guide that i came up with in stage one
one of the only things that you can look at is what i call the price to hope ratio you're
basically judging the company based on its story and fingers crossed that it works out this is how
a lot of venture capitalists invest in stage two the company is starting to have some revenue and
you actually have sales to look at the only way to value a company is based on something called the
price to sales ratio after you get to the hyper growth phase there is earnings hooray however
it's too early to look at the company's price to earnings ratio because of that i think it's
more useful to look at other metrics like price to gross profit price to ebit or even price to free
cash flow it's only when you get to stage four and a company is fully optimized for profits that
the price to earnings ratio becomes useful finally in the fifth stage there's really nothing you can
look at if that business is heading for bankruptcy no valuation metric will matter the trouble that i
had as an investor is i thought that the price to earnings ratio was universally applicable across
all the other phases and that actually turned out to be a big mistake you actually often can't use
the price to earnings ratio on a company that's in the hyper growth phase or in the launch phase
a classic example of this for me was when i thought about becoming an investor in amazon
you rewind the clock to 2004 and amazon's price to earnings ratio was 675
immediately it was a pass for me way too expensive and after i passed on that stock what did it do
it just went up six thousand three hundred and ten percent from there amazon it was a fantastic buy
in 2004 even though its price to earnings ratio was 675. how could that be well let's look at
the numbers that brian saw at the time we saw that revenue was about 5.3 billion but importantly you
have to look at how much was the company spending and that orange line being above the purple one
means that they were losing money for a huge chunk of time and had only just recently become
profitable meaning that their earnings per share was just eight cents now let's think about that
for a second eight cents of earnings per share and what that's going to do to the p e ratio if we
do the math we see that the stock on january 1st 2004 traded for about 52 dollars per share because
it only earned 8 cents looking backwards that meant its trailing p e ratio on that day was 657
way too expensive to buy but let's look at what happened over the next year
we see that sales continue to grow at the same pace however expenses didn't grow quite as fast
meaning that the gap between the sales and the expenses grew that means that the earnings per
share went from eight cents per share on january 1st 2004 to a dollar and 39 cents per share
that might not seem like a big jump nominally but on a percentage basis it's huge and if you could
have known that it would be a dollar 39 cents then back on january 1st 2004 if you figured
out the forward p e you would have used the same price but you would have divided it by a
different denominator and that changes the picture dramatically all of a sudden the pe is under 40.
still expensive but nowhere near as unreasonable as 657 so that just gives you one idea of how
to do it but even that wasn't the right metric to use the trouble in 2004 was that amazon was still
early on in its hyper growth phase and if you looked at the company's long-term revenue growth
trajectory it was enormous there was no way to know in for sure in 2004 that this is about to
happen but if you studied the company's business you knew that the potential was certainly there
and going back to my chart for a second if you look at where amazon was on this chart in 2004
the answer was about here so it was a mistake to look at the price to earnings ratio at this point
simply because the company was about to enter the hyper growth phase and importantly it
wasn't fully optimized for profits so the price to earnings ratio looked extremely high but that was
a misleading metric to use so let's look at what brian would have seen if he would have known back
then that he should have looked at that here again we see the revenue but this time we're just going
to compare to the cost of goods sold in other words it will give us what the gross profit was
and that gross profit when you subtract those two was 1.26 billion dollars importantly gross profit
was growing faster than both sales and expenses meaning that there was significant leverage that
the company was experiencing so let's take this information and look again we see that on january
1st yes the p e ratio was 657 but if we just looked at the price to gross profit as brian
pointed out that comes to a much more reasonable ratio of 17 and gross profit was growing at 37
per year over the past four years we've just taken amazon from wildly overvalued to a pretty
good deal in short order now obviously amazon is an extreme outlier in so many ways that's not
the point we want to hammer home the point wanna hammer home is that the p e ratio is a fantastic
metric for judging the value of a company but only when the company is fully optimized for profits
if the company is in high growth mode and is purposely reinvesting into itself rapidly
that's going to depress the earnings power of the company by and that depression of the earnings
power of the company makes the p e ratio look enormous so if you look at some of the fastest
growing companies on the market today many of them trade at sky high price to earnings ratios one of
the reasons that could be happening is because they are about to enter the hyper growth phase
of their profits so the p e ratio is a misleading metric one final example that really hammered
home this point for me was an article that one of my favorite writers morgan housel produced
several years ago in 2012 morgan looked at the 30 components of the dow jones industrial average
and he asked himself what price to earnings ratio did these companies trade at in 1995 then he said
what p e ratio should an investor be willing to pay in 1995 in order to earn a market matching
return and here's what he calculated now this might be slightly hard to read because it's small
there's several examples of companies on this on this chart that traded at seemingly high p e
ratios that were actually dramatically undervalued how could they be undervalued even though they
traded at high p e ratios they were going to remain in high growth mode for a far longer time
than market participants were assuming one simple example here is to look at united health in 1995
united healthcare traded at 28 times earnings it was one of the most expensive stocks on this list
however an investor should have been willing to pay 76 times earnings for this company
in order to earn a market matching return in other words united health at 28 times earnings
was actually dramatically undervalued because it held such high growth potential conversely there
were several stocks in this list that traded at seemingly cheap price to earnings ratios
that were actually dramatically overvalued alcoa for example traded at 10 times earnings in 1995
and yet in order to earn an 8 return you had to pay three times earnings for the company so
while it traded at a cheap price to earnings ratio the company was actually dramatically overvalued
why because its profits and revenue growth was going to be very very low for the foreseeable
future so we hope you can see that we're not saying that the pe ratio is a useless
tool it can be very useful but like all tools you need to use it in the right situation and
under the right circumstances this is a mistake that i made so many times as a new investor
when i learned about the p e ratio i applied it everywhere that i looked and it caused me
to not buy so many of the greatest stocks on the market after i finally wrapped my
head around the fact that companies can trade at high p e ratios and be undervalued that's
when my return started improving for the better well thank you so much for watching this video
we hope you enjoyed it how do you use the p e ratio let us know in the comment section below
my name is brian feraldi and my mission is to spread financial wellness and my name is brian
stofel and my mission is to minimize finances as an obstacle to wholehearted living brian's out