So I m sure you ve all heard the popular trading saying Buy low sell high . But how do you
know if a specific stock is at a low point or a high point? How do you know if a certain
stock is cheap or expensive? We ve all been there. You see a stock. You
think it s at it s bottom. So you buy. But then right after you buy, it keeps falling,
and falling. And it ends up you didn t buy the bottom at all, you bought the middle.
This little mistake can cost you thousands of dollars, and it probably already has lost
you money. What if there was a secret stock rating system.
Where you can just simply look up a company. See a rating, and instantly know if that specific
company is over or undervalued? Well, in this video I m going to tell you
exactly how to do that. So you are only investing in companies that are at a good price and
you are getting the best bang for your buck. Let s jump straight into it.
Whenever you type a certain ticker symbol in on google, like apple for instance. It
s going to give you a bunch of key metrics for that ticker symbol. Like the open, the
high, the low, and the dividend yield. but what we are going to be specifically looking
at is the P/E ratio. The P/E ratio stands for the price to earnings
ratio. It s heavily used by investors and analysts because of the great value it can
present. It s usually used in most cases to see if a company is overvalued or undervalued.
You can get this number, by taking the price of the stock and dividing by its earnings.
Or by just looking it up, which is what I normally do.
Generally, the higher the P/E ratio, the more overvalued the company is.
So, a P/E ratio of 15 would mean that the current market value of the company is equal
to 15 times its annual earnings. Think of it like this. If you were to hypothetically
buy 100% of a company s shares with a p/e ratio of 15, it would take 15 years for you
to earn back your initial investment through the company s ongoing profits.
That s why usually you want to look for a lower p/e ratio because it hypothetically
would take less time for you to make your money back.
So I m sure most of you are scrolling through 100 s of stocks right now trying to find the
lowest P/E ratio possible so you can make millions of dollars on undervalued stocks.
Right? If only it were that easy
Just like all financial metrics, there is always downside. It s not as simple as just
finding the lowest P/E ratio. The original P/E ratio is known as the TRAILING
price-to-earnings ratio. This is because it uses numbers from the past. This can be a
problem because some would argue that the stock market is not only built on the past
but also the future. Just because a company did good in the past,
doesn t necessarily mean it will do good in the future.
This can be a problem for the trailing p/e ratio, because it doesn t take a lot of things
to account. Like what if a company just hired a new amazing CEO? Or they just released a
new spectacular product? Or what if they found a cure for cancer? All of this amazing news
would make the stock sky rocket. But the P/E ratio wouldn t be affected at
all, at least at this very moment. because instead of looking at the present and the
future, it s looking at the past. That s when the forward P/E ratio was invented.
Unlike the trailing p/e ratio, the forward p/e ratio looks at projected earnings. So
instead of looking at the past, we are looking at the future. But of course, there s an absolute
clear problem with this. What if the estimated earnings are wrong?
What if the company purposely underestimated earnings in order to beat them easier? Or
maybe analysists just simply get the projected numbers wrong.
There s a lot that can go wrong with a forward P/E ratio too, and that s why a lot of investors
like the trailing one, because it uses actual numbers rather than just guestimates.
So I ve listed some of the problems with both the trailing and forward P/E ratio. But what
if I told you a company had a p/e ratio of 10. How can you tell if that is good or not?
One of the ways, is to compare a company s P/E ratio with it s historical P/E ratios.
That way, you can see how the number is changing over time. This will kind of give us an example
if investors are valuing the company higher or lower than normal.
So say a companies earnings are going down, but the price is going up. This mean the gap
between the two, which is the P/E ratio is getting bigger. Meaning, people are spending
more money on less profit. Same goes the other way around. If the companies
earnings are increasing, but the price is falling. That means the gap is getting smaller.
Which means the P/E ratio is getting smaller. Meaning investors don t value the profitability
of the firm as much as they use to. What a lot of investors like to do is compare
the current P/E ratio with the long term average. So hear we have Apples P/E ratio from the
past 5 years. We can see that the lowest P/E ratio from these 5 years was 11.69 and the
highest was 41.80. Giving us an average of 22.41.
But as we can the P/E ratio right now is 30.64, being over the average, which may be indicating
the stock is overvalued. Here Intel s P/E ratio is below the average.
Which may indicate good time to buy because of mean reversion. Meaning, the P/E ratio
is expected to head back to its average. A lot of investors believe that a lot of short
term volatility to P/E ratio whether that s from a bad press release, or something bad
happening in the short term, will merely just be a leaf in the wind and not have a huge
effect in the grand scheme of things. Resulting it heading back to its normal average.
Just like a stock chart. So yeah there was a dip and it may seem like a big deal at the
time, but if we go in the future and zoom out, it wasn t a big deal at all, and the
stock continued to head back to where it was before.
So that s why a lot of investors believe if a companies current P/E ratio is lower than
the long term average P/E ratio, it might be a good time to buy, because the stock is
likely to head back to it s long term average. Alright cool, so I can just go look for companies
that have a super low P/E ratio compared to their long term average and I can make a ton
of money when it returns back right? Well again, it s still not that simple.
So yeah, its great to know how a company stock price stands compared to the past, but you
should also be comparing that stock to others in the same industry. Let me show you why.
So say if we have stock A trading at $30 and stock B at $20. So which company is more expensive?
A new investor might assume stock B is the better value because it s the cheapest.
But this isn t necessarily true. The P/E ratio can help us with this from a valuation stand
point, to tell us which will give you a better bang for your buck.
So let s just these two companies are both in the banana industry. I don t know. And
the average banana company has a P/E ratio of 15. Let s say company A s P/E ratio is
15 , and company B has a P/E ratio of 30. Company A is actually in a way cheaper, even
though its stock price is higher. Because it has a lower P/E ratio, basically saying
we are paying less for every $1 of it s current earnings.
This is why its usually good to compare a companies P/E ratio with the sector s average
But yet it again, its not this simple. Just because a company has a higher P/E ratio than
it s sector average, doesn t necessarily mean it s a bad buy.
So banana company B has a P/E ratio of 30 and the average banana company has a P/E ratio
of 15. It can still be justified why company B s ratio is soo much higher. They could be
earning their earnings at a much faster pace. Resulting in higher p/e ratio.
This is why high growth companies like those in the tech sector have higher p/e ratios
compared to stock in slower moving areas, like utilities.
So just because a company has a p/e ratio lower than the average in its sector, doesn
t necessarily make it a good buy either. If a company doesn t have good fundamentals,
its doesn t matter how low the P/E ratio is. That s why you shouldn t just be solely looking
for low P/E ratios, because there could be a reason why its quote on quote undervalued.
Think of it like this. Lets go back to both of our banana sellers. One seller is selling
their bananas for $5 per banana, which is kind of like saying it has a 5 p/e ratio,
then we have another seller selling bananas for $1 per banana. Saying it has a 1 p/e ratio.
So we decide to buy the cheaper one. But as we all know, cheaper isn t always better.
So when we get home, sure the outside of the banana looks good and we got it a lot cheaper,
when we open it up, its all black on this inside, and not very appetizing.
So just because somethings cheap doesn t mean you should buy. A low P/E ratio could be justified
by it being a bad company. That s why it s not a good idea, just to purely look for companies
with low p/e ratio, because more often than not, you re going to get some bad bananas.
So in the making of this video, it s almost as if im saying P/E ratios are useless. It
s not useless by any means. It can be a great way to identify quickly if a stock is over
or undervalued. But it should never be used by itself. They are a rough gauge of a company
at best. A good approach is finding companies with
good fundamentals, so finding bananas that are solid yellow, tasty, big, and grown to
perfection. Then look between those solid companies and look at the p/e ratios, to see
if you can find a good deal between those solid companies.
Because as said before, cheaper is not always better. You should be looking for quality,
then discounts. One of my favorites quotes about this style
of trading is by warren buffet. it s far better to buy a wonderful company
at a fair price . Than a fair company at a wonderful price . And that holds so damn true.
This is just one of the mistakes I see traders commonly make. If you want to see the 6 biggest
trading mistakes that keep you losing money. Check out this video, it s pretty eye opening
and you re probably making some of them. Thanks for watching and ill see you guys, next time.