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…