If you’re new to investing, learning how to choose stocks and investing in the stock market can be overwhelming. Probably the largest mistake that young investors make is to look at the price of a stock as a measure of its worth. In fact, the price of a stock is virtually worthless when trying to value a company.
So what metrics should investors use when evaluating a potential stock investment opportunity? While there are numerous factors to take into consideration, the most popular and well-known metric is known as the price to earnings ratio, or the P/E ratio. But before we get into explaining this ratio, let’s look at why the price of the stock doesn’t tell the whole story.
Stock Prices – Cheap vs. Expensive
Think about something in your life that you know very well. Maybe you’re obsessed with computer upgrades and performance. You know everything there is to know about computers and when you go to a computer store; when you look at the prices and the specs, you truly know what represents a bargain.
If you were helping a friend pick out a computer, you might tell them that a computer on sale for $2,000 may be a better bargain than a computer on sale for $500. Maybe the $2,000 computer has a bigger screen, more storage space, and $500 of preloaded software on it. With the $500 computer, not only is the hardware pretty shoddy, but there is also no preloaded software, meaning you’ll have to shell out extra money once you bay the computer. You might say “you get more bang for your buck” with the $2,000 computer. It is this same line of thinking that should be applied to stocks.
Unfortunately, many young investors do not apply the same logic to stock picking. Instead, they look at a $340 stock like Apple and call it expensive. So they head to a little known penny stock that is selling for 50 cents and buy it up like it’s pure gold. The fact of the matter is that if you only have $1,000, there’s a good chance that you’ll make more money purchasing three shares of Apple rather than 4,000 shares of that cheap company. Why? Because Apple is a much more stable company with not only a proven track record of making investors money, but also strong growth potential.
The P/E Ratio Defined
Now that we’ve fixed the flaw in the young investor’s logic, let’s look at how to measure value. It’s a little more complicated to evaluate stocks than it is to evaluate computers since there are so many different factors involved.
However, there is one metric which, while it doesn’t make up the entire story, offers an important piece of the puzzle when valuing a company: the price/earnings ratio, often referred to as the P/E ratio or P/E multiple. This ratio, while only one of many that sophisticated investors use, is the most popular and discussed ratio in many investment books.
So how does the P/E ratio work? Think of it this way: let’s say you are considering investing in two public companies, both of which are selling for $20 per share today. One way of deciding which company to invest your money in is examining how much you will need to pay for $1 of earnings from each company. If last year, Company A earned $5 per share and Company B earned only $4 for share, it would intuitively make sense to choose Company A over Company B since it represents a cheaper trading opportunity. Without even realizing it, you’ve made this decision by calculating each company’s P/E ratios.
The P/E ratio is calculated by taking the current price and dividing it by the earnings per share. In the example above, you would take the price of $20 and divide by $5 for Company A and $4 for Company B, yielding ratios of 4x and 5x, respectively. If you’re not good with math, you can also easily find the P/E ratio in the fundamental analysis section of your broker’s research screens for the stock you’re reviewing or on various stock market investment news and research sites.
Disadvantages of the P/E Ratio
While the P/E ratio is a valuable metric for investors, you don’t want to make the mistake of thinking that a P/E ratio alone tells the whole story. Here are the main limitations of the P/E ratio:
- Healthy P/E ratios may differ between industries. The concept of using a set P/E ratio to determine if a stock is overpriced fails to take into account the individual nature of the underlying company. Stocks in high-growth industries like the technology industry tend to have higher P/E ratios. On the other hand, some industries such as utility companies tend to trade at much lower multiples. Before you can decide if a stock is under or overpriced, you need to take into consideration the industry in which it operates. Continuing with the example above, let’s say Company B was a high-growth tech company forecasted to earn $15 per share next year and $25 per share the following year, while Company A was a low-growth oil company that was forecasted to earn $6 per share next year and $7 per share the following year. Now that you have a fuller picture of the two companies, it becomes clear that Company B would in fact be the better company to invest in due to its massive growth potential. Company B’s stock price will likely skyrocket if the forecasts are correct, while Company A’s stock price may not budge by much over the next couple of years. Thus, by ignoring other aspects of the company, an investor might have falsely assumed that Company A represented the more valuable stock opportunity.
- Fails to consider the debt of a company. The price of a stock reflects the equity value of a company. However, it is also important to consider how much debt the company holds. An investor should never ignore a company’s debt position when buying a stock since debt is a strong indicator of a company’s financial health and future.
- Earnings can be manipulated easily. Clever accountants have a million and one ways to make companies look more attractive. This can involve changing depreciation schedules, using different inventory management strategies, and including non-recurring gains. These strategies are not limited to corrupt organizations like Enron, as firms are given some legal flexibility in how they choose to report their earnings. As a result, because companies have an incentive to make earnings look as attractive as possible, P/E ratios can be presented as being artificially low.
- Growth companies trade at higher P/E ratios. Since P/E ratios represent not only a company’s current financial situation but also it’s future growth potential, growth stocks trade at significantly higher P/E multiples than value companies. Thus, without understanding what type of company you are considering as an investment, you might carelessly overlook some valuable growth companies simply because of their P/E ratios. In fact, some of the biggest winners of all time have been companies with high P/E ratios. According to Investors Business Daily, in a recent analysis, the top 95 companies had an average P/E ratio of 39 before gaining momentum and reaching an average P/E ratio of 87 at their peak. Yet according to the models of most investors who rely solely on P/E ratios, all of these companies would have been ruled out as being overpriced.
- False assumption that low P/E ratios represent cheap trading opportunities. Many investors assume that a company trading at a P/E ratio must represent great value. As we know, because of many of the factors stated above, low P/E ratios do not necessarily make the best investments. For example, Countrywide Financial was a company that was trading at single digit P/E ratios before it crashed.
P/E ratios are a valuable tool for investors, but they are not sufficient to identify the feasibility of an investment unless used in combination with other metrics and company characteristics.
Regardless of your opinion on the P/E ratio, you should always examine other ratios as well before buying a stock. These metrics, which help investors evaluate other aspects of a company, include Enterprise Value/EBITDA, Enterprise Value/EBIT, Enterprise Value/Revenue, Price/Cash Flow, and Price/Book Ratio.
The P/E ratio is a great start to understanding a company’s value proposition as a potential investment. With that said, don’t forget that there are many other ratios and factors to consider other than the P/E ratio. The P/E ratio is just one piece of the puzzle. And if you only take one lesson from this post, remember this nugget of information: the price of a stock, in and of itself, is a poor indicator of value!
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