Month: October 2018

Never forget these two axioms:

Money frees us, but its pursuit enslaves us.

It’s not how much you have at the end; it’s how much you could have made.

 

Where we last left off, we discovered the range of PE ratios between some famous tech stocks (Microsoft/MSFT=51.01, Apple/AAPL=19.87, Facebook/FB=23.84) and will use that metric to determine which to purchase in a hypothetical $10,000 purchase. (Just like med school, let me set up a hypothetical that is unlike real life and make you stick to it. In this case, that means all $10,000 must go into only one stock rather than splitting it up into two or even all three companies.)

Before we dive into the comparison analysis, let’s review the PE ratio as a number and what it means. So, as you (hopefully) saw from last time, the PE ratio of the S&P 500 has essentially been between 15-25 for the past 15 years or so (with the major exception being in 2009 as noted last time). Thus, our evaluation has been pegged to PE ratios in this range.

***Note that in all future posts, if I refer to a low PE ratio company, it’s below this range (or at the lower end of this range) or a high PE ratio company would have one greater than 25.***

A low PE ratio company is considered “cheaper” regardless of its actual stock price and how much you have to pay for the same number of shares as a company with a higher PE ratio. This is part and parcel of the school of thought known as “value investing” (though they are other metrics used to determine what is a value purchase among stocks) which is what made this guy rich and famous.

A high PE ratio isn’t necessarily a bad company however. A high PE ratio for a company means that the stock price is high when earnings are relatively low.

Sarcastic Reader: Why in the world would that be? Wouldn’t the stock price be low if the earnings are low?

Dr. Scared: This is it! This is how they screw you!!

Dr. Unwise: Low earnings, but a high stock price? That makes no sense at all!  

A high PE ratio means that analysts/institutional investors (maybe even retail investors) expect earnings to take off in the near future (a totally and purposefully arbitrary and vague time period) based on…something…like a new product launch, a new division, a new acquisition, etc. How much that is worth may be subjective and it is up to you as in individual investor to make that call particularly if the PE ratio in question is multiples of that of the S&P 500.

Keeping all that in mind, let’s do some comparison shopping.

From purely a PE ratio, the “cheapest” company is good old Apple with Facebook as a close second and Microsoft a distant third.

Sarcastic Reader: So Apple is the best one to get right?

Dr. Unwise: I feel like there’s a catch here somewhere.

Dr. Scared: This is it! This is how…Aah, you guys know where I’m at with all of this…

PWT: Yes. Apple is the best company to buy into from a purely a PE ratio. There is no doubt about it. But, there’s something else—if not other things—to consider…

Sarcastic Reader: Oh boy, Here we go…

One other thing you need to consider when thinking of buying a stock is if it pays a dividend and what is the company’s dividend history if it does pay one. Facebook does not pay any dividend. Both Apple and Microsoft do pay dividends. Microsoft paid 0.42 per share of stock you own and will pay $0.46 per share starting in November which is a dividend yield of 1.7%. (Think of dividend yield as interest gained on the money you put into that particular company. That plus how much the stock price goes up [AKA capital appreciation] along with how much the company keeps increasing the dividend payout {if they do at all} will determine how well you do with that individual company.) Microsoft, for example, began paying out dividends in 20003 and has steadily increased its dividend every year since 2009 from 13 cents/share to 46 cents/share starting next month.

Apple, on the other hand, pays 73 cents/share with a dividend yield of 1.4%. Apple has increased its dividend every year since it re-started one in 2102. It had a dividend in 1988-1995 and none before that or since then until 2012.   

So, Apple has a more inconsistent dividend history in that it had one and suspended it previously. The counter argument here (by Apple fanboys) is that the company has a pile of cash that even Croesus would envy and will continue the dividend ad infinitum if not increase it occasionally.  Moreover, it has a far lower PE ratio (19.87) than Microsoft (51.01).

Sarcastic Reader: So…Apple…then?

Dr. Unwise: Please…please. I’m begging you in all the name of the holy, say Apple or nothing else makes any sense right now.

Dr. Scared: This is it! This is how you they screw you!!

PWT: In this contrived hypothetical, I’d pick Apple. This is where you get into investor biases and recognizing what your biases are.

Dr. Know-It-All: OK, smart guy. What are yours?

PWT: Hey, not welcome back, but long time no see. I had no idea where you went. My biases are clear: I am a value investor and always seek a good company with a long history whose business model I can understand and even more so if they have a good dividend history (ie, long history of paying out dividends consistently and best yet if the company keeps nudging the dividend up year after year without fail). The only other company types I look hard at are the ones that will be increasingly important given future needs/trends such as social media, cloud computing, 3D printing, technology, and—believe it or not—even water.

Apple checks all those boxes. In practice, however, you could easily split your money into $5,000 into Apple, $2,500 into Microsoft, and the remaining $2,500 into Facebook, betting on all three for the long term future and capturing the dividends of the former two while waiting patiently. And the dividends should then be set up to buy more shares of the stocks you already have evaluated as good buys which sets you up to keep buying more stock for no more money out of your pocket(s) ever again. This is the cheapest way in the world to dollar cost average and accumulate wealth over time.

Dr. Know-It-All: Um…thanks…

Dr. Spend-It-All: I’d just make the dividends come to me. So I can buy some jet skis for the lake.

Dr. Unwise: SOme? One isn’t enough.

Sarcastic Reader: Wait a damn second, Professor! We went through this whole exercise based on the fact that you could only pick one stock and not all three just like in medical school when they ask a question with all good options, but say there’s only one best choice. And then finally after a lot of flim flam you give the answer kind of and then tell us that “Oh, yeah, by the way, I’m changing all the rules now and would buy all three in real life.” What gives?

PWT: Welcome to medical school where students never win. Same with residents and fellows.

Dr. Unwise: Damn. So true…

Dr. Scared: This really is how they screw you!

OK.

Enough.

I’ve tortured everyone here long enough.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word about this blog to your friends (real and virtual), family, and colleagues. Talk to you soon.

Until next time…

Never forget these two axioms:

Money frees us, but its pursuit enslaves us.

It’s not how much you have at the end; it’s how much you could have made.

Sorry for the delay recently, Once again, life got in the way, but back into it we shall go. We last left off talking about the PE ratio in its definition, how to interpret it, etc. Now that we did the theory work, let’s do the practical part (just like med school—Ugh).

Let’s keep using Microsoft (MSFT) as an example and then we can do some comparison shopping amongst the tech stocks.

Microsoft currently has a PE ratio of 51.01 with a stock price of 108.66. The current PE ratio of the S&P 500 is 22.60 (estimated as of 10/19/18) and was 24.97 on 1/1/18. (If you peruse the table at the other end of the link, you will see the PE ratio of the S&P 500 has steadily been rising since 2012—from 14.87 to over 20 today. This keeps cycling up and down as you can see in the table.

The highest PE ratio of late was the incredible 70.91 as of 1/1/09—as the market as a whole was sinking and wouldn’t find bottom for ten more weeks in mid-March. Everyone was focusing on how much stock prices were dropping, but earnings were plummeting even further thus making the PE ratio [remember that stock price is your numerator, but your denominator is the earnings—who know all that elementary school math would bubble back up in your adult life?] at the time spike up. You can then see as the market recovered the PE ratio fell back to normal human heights 20.7 by 1/1/10.)

So, what exactly does all this mean in terms of evaluating MSFT as a potential buy?

Comparing apples to apples (even if they are Red Delicious [a misnomer for sure] versus Gala—7,000!?! Wow. Who knew?), the MSFT PE ratio is 51.01 versus that of the S&P 500 (current estimation) of 22.60 meaning that MSFT is 2.257 times more “expensive” than the average stock in this market. Maybe that’s OK though. Purchasing is a matter of not only price, but value. You don’t get a 4,500 square foot house in the best neighborhood in town for the same price as a 1,200 square foot place in the sketchy part of the same town. We all buy the same things at very different prices and feel (are sure?) that we are getting a good value for the money we are parting with.

But, to compare with MSFT with the average stock in the market isn’t quite fair. If you’re car shopping and say that a Mercedes is far more expensive than a Kia, you’re absolutely correct and also stacking the deck in a ludicrous argument. You need to compare your Mercedes to other luxury vehicles (BMW, Audi, etc.—yeah, I like German cars). The same is true with stocks.

So, MSFT needs to be compared with the other well know multibillion technology stocks out there not the Proctor & Gambles  and Coca-Colas of the world.

So, in terms of PE ratio (rounding to the nearest whole number), MSFT is 51, Facebook is 24, Amazon is 140, Apple is 20, Netflix (a technology company of sorts) is 119, and Google (never Alphabet in my view) is 47. These are the famous so-called FAANG stocks.

Sarcastic Reader: Hey fella, Apple at 20 and Facebook at 24 is way cheaper in terms of this PE ratio thing. Why not just buy one or both of them instead of Microsoft?

Dr. Scared: This is it! This is how they screw you!!!

PWT: Great point. Let’s compare MSFT vs Facebook  vs Apple as far as if you have $10,000 and want to put it all on one stock all at once right now…next time.

Dr. Unwise: Damn it! This guy is getting good at the tease!

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word about this blog to your friends (real and virtual), family, and colleagues. Talk to you soon.

Until next time…

Never forget these two axioms:

Money frees us, but its pursuit enslaves us.

It’s not how much you have at the end; it’s how much you could have made.

When evaluating individual stocks, much is made of the dreaded price earnings ratio (AKA PE ratio) which makes the eyes of many glaze over and nod in silent hopeless agreement. Defining what it is is far easier than how to interpret it.

PE Ratio=A company’s stock price/earnings per share

This is typically calculated by the four past quarters of earnings divided by the annual earnings per share. This is defined as the trailing P/E (or PE) ratio.

For example, if a publicly traded company has a stock price of $20 and the earnings per share is $2 over the past year, then the P/E ratio is 10. (I like simple math.) Note that the PE ratio is not in dollars or foot pounds or some such thing. It’s just a number and that’s it.

So what? What does this mean?

Who cares?

So what exactly does this number signify?

This number tells you how much you are willing to pay for a company’s stock. Think of it this way. In the above example, it means you would be willing/you will be buying a piece of a company at ten times what they earn for each of those shares you purchased. You can compare this PE ratio of company A to either other companies in the same sector (eg, pharmaceuticals, energy, utilities, etc) or even the whole stock market. If the company in question is way out of scale with either its sector or the market as a whole, it should give you pause and make you figure out why should you be paying so much more for this stock as opposed to others (whether in that sector or in another completely different one). If you cannot definitively prove (at least to yourself and your significant other) why this stock is worth so much more than many others, then don’t buy it. I completely agree with the Warren Buffet maxim of “Buying a great company at a good price is much better than buying a good company at a great price.” (I’m paraphrasing the Oracle of Omaha, but it captures the essence of what he was getting across.)

The caveat to this is ensuring you’re getting at least a good price, if not a great one. (More on that later.)

Due to the fact that company earnings only come out quarterly and the stock price changes daily, the trailing PE ratio keeps moving daily. Therefore, many investors pay heed to the “forward” or “leading” PE ratio which is calculated with the same methodology, but using projected future earnings (essentially always estimated over the next 12 months).

Now you have two PE ratios competing against one another for each stock that exists.  

Sarcastic Reader: OK. Here we go. This is how the flim flam starts.

Dr. Scared: This is it! This is it!! This is how they screw you!!

Dr. Unwise: Just once i’d like to finally find out who ‘they” is.

PWT: Umm…let’s just…keep moving…on…

If the leading (or forward) PE ratio is lower than the trailing PE ratio is, it means analysts are anticipating the company’s earnings to increase over the next 12 months.

However, if the leading (or forward) PE ratio is higher than the trailing PE ratio is, it means  analysts are anticipating the company’s earnings to decrease over the next 12 months.

To further confuse the issue, there is something called a PEG ratio (price to earnings growth ratio) which is the company’s trailing PE ratio divided by the growth rate of the company’s earnings for some specified time period (again, typically a year). PEG ratios themselves can be categorized as trailing or leading/forward depending on whether historic growth rates or estimated future growth rates respectively.

The instance where PEG ratios are often used is when you seem to have a “steal” in a low PE ratio (“cheap”) stock to see if that is truly the case as the PEG ratio accounts for the growth a company is undergoing as it is moving along which may indicate not where it is now, but what you want to know most—where it will be in the future. (More on this later.)

The companies that do not have any positive earnings have either a negative PE ratio (my preference), just arbitrarily assigned a PE ratio of zero, or even more ambiguously the PE ratio is unassigned and noted to be uninterpretable since some argue the PE ratio cannot be used to compare this company to any other. (More on this later…I hope we have time for all of this later stuff.)

Now that we have defined the PE ratio and its variants, let’s go thorough an example of a stock and run it through an analysis of how they should be viewed through the prism of PE ratios.

Good thing there’s always another week coming up…

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word about this blog to your friends (real and virtual), family, and colleagues. Talk to you soon.

Until next time…