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…