Last week we looked at Return on Equity (ROE) as one of the many criteria for picking an individual stock. Today we will look at another area to consider before buying any single stock. And brace yourself for more to come after this! This is but one of many articles to come about picking stocks.
Today we'll examine the price-to-earnings (P/E) ratio. Yes, it's another math formula to consider when looking whether or not to buy stock, but no need to panic! It isn't too complicated. Here it is:
P/E = market value of your stock per share/earnings-per-share over a 12 month period.
(Again, the / means 'divided by.' I wish I could type an old-fashioned division sign. I am showing my age.)
So what is this?? And why do we care? We care because knowing what this number means helps us understand the real value of a company's stock. It can be helpful in seeing whether a stock is over-priced or under-valued.
Continuing on, let's look at the equation above and define what it means.
- Market value is the price your stock is trading for each day.
- Earnings-per-share (EPS) is the profit that stock has made over the course of the last year (minus dividends paid) divided by the number of shares held by all its shareholders (AKA 'outstanding stock').
There are 3 kinds of P/E ratios:
- trailing P/E: this is calculated based on data from the past 4 quarters (also typically known as a year). This is calculated from actual data.
- rolling P/E: a blend of the past 2 quarters and what the projected estimate of the next 2 quarters will be. Half of this actually happened in real life, the other half is what is projected to happen.
- forward P/E: this is based on what the next 4 quarters are expected to be. But it hasn't happened yet.
Are you still with me?
Since I like concrete examples, concrete is what I will illustrate this with for your reading enjoyment. Let's say Rupert has an exchange-traded company that sells raw hides (called Rupert's Rawhides) , and Marley has one that sells treats (called Marley's Meaty Treats). You want to buy one or both of these stocks. Which one do you pick? Knowing the P/E of each stock can help you decide.
First, let's calculate the EPS, or earnings-per-share. Remember, this is expressed like this:
EPS = profit - dividends/outstanding stock
So now let's look at the 2 companies:
Rupert's Rawhides!
This CEO stands behind his tried and true product
Over the past year, my entrepreneurial dog Rupert has made a profit of $100 selling his raw hides. He has paid out $10 in dividends to his stock holders. In all, he has sold 25 shares of stock. Plugging in values for the above equation, we have--
- $100 (profit) - $10 (paid dividends) = $90
- $90/25 shares of sold stock= $3.60 earnings-per-share (EPS) for Rupert's Rawhides
Next, let's look at ---
Marley's Meaty Treats!
While camera-shy, this CEO knows she has a winning product
Over 12 months, Marley has made a profit of $150 selling her meat treats. She doesn't paid stockholders; rather she takes any profits and reinvests them into her company so it can expand. In all, Marley has sold 50 shares of stock. So...
- $150 (profit) - $0.00 (paid dividends) = $150
- $150/50 shares of sold stock = $3.00 earnings per share (EPS) for Marley's meaty Treats
So although Marley has made more profits and sold more stock, Rupert's earnings-per-share is higher, as $3.60 > $3.00. But this alone is not enough information for anyone looking to buy stock in either company. You need more information!
Calculating the Price-to-Earnings ratio
So now we can calculate the P/E. Both Rupert and Marley own companies within the same industry, so they can be fairly compared. You wouldn't compare their companies' P/E with that of Microsoft, for example, which is in the software industry. So when shopping for stocks, you compare apples to apples when it comes to P/E, not apples to oranges. Otherwise the information is meaningless.
Let's say Rupert's stock is trading at $50 per share. That is the market value of his stock. So now we need the formula for the P/E:
P/E = market value per share/earnings per share,
P/E ratio for Rupert's Rawhides = $50(market value) / $3.60 (earnings per share) = 13.88
Marley's stock is selling at a slightly higher price of $60 per share. So the
P/E on Marley's Meaty Treats = $60 (market value) / $3.00 (earnings per share) = 20.00
So what does the P/E show? It shows that if you buy Rupert's company, you will be investing $13.88 for every dollar of earnings Rupert's company makes. Likewise, it shows that you you will be investing $20.00 for every dollar that Marley's company makes. To justify the higher price of Marley's stock, Marley's company is expecting to grow more quickly than Rupert's. There is potentially more money to be made with Marley's stock. And that there is more at stake for you as an investor.
A rising stock price results in a higher P/E. We can expect Marley's stock price to increase more rapidly than Rupert's based on its P/E, but it may simply be over-priced. With the higher P/E, the hope is that something worth the risk will come along down the road.
If the price of a stock goes down, the P/E will also lower. Stocks with lower than average P/Es are often value stocks. Stocks with higher P/Es are often growth stocks.
This means very little without a reference. That reference is relative to the stocks' industry average. Let's say the dog treat industry average's P/E is 16. Rupert's company's P/E is less than that, so it may be a bargain with a P/E lower than the industry average. It may be a safer stock with less risk on than Marley's.
Marley's may be the better stock in terms of growth potential, though. If Marley's company starts earning as expected, the investment may pay off in a bigger way than Rupert's over time. But if her company doesn't grow as she expected, the stock price will most likely fall. If you bought Marley's Meaty Treats at a higher price, that would be pretty disappointing. (Which is why we buy and hold for the long term. And don't flip out every time the market fluctuates.)
Whether a P/E is considered high or low boils down to is this:
- What the industry average is overall. That means Marley's company maybe looking to more profits with increased efficiency in the future to justify the higher than average price and corresponding P/E. So the reward may be greater, but so is the risk.
- A company's projected growth rate for the future should be in line with its P/E. This is where we come to part 2, which will be in the the next article: earnings growth comes into play. Earnings growth is the increase in a company's earnings per share over the course of several years.
See you next time!