Let’s explore the idea of “value.” That is, the concept of paying a good price for a stock — not just finding a good company and paying whatever the market is currently asking.
One of the most common valuation metrics to assess what a stock is worth is a price-to-earnings ratio.
The price-to-earnings ratio is exactly what it sounds like — you take the stock’s price and divide it by the earnings per share. So if a stock is at $50 and is set to post EPS of $5 this year, you have a P/E ratio of 10.
Well, stick with me. Price-to-earnings ratios get a bad rap on Wall Street because many people apply a one-size-fits-all approach that does more harm than good. When used correctly, however, P/E ratios can tell you a lot about how fairly valued a stock is.
Investor sentiment is key to many big moves in the market. So your trick is to make sure you’re not late to the party, enthusiastically buying the hot stock that everyone was so enthusiastically buying months ago at a much better price.
To help prevent you from missing the run-up in a good stock by buying after the surge, you need to use future estimates for earnings. They might only be estimates and subject to change, but if you base your P/E on last year’s profits, you are doing yourself a great disservice. The future value of your shares certainly is not tied to old profits, but the profits yet to come.
Let’s use Apple (NASDAQ:AAPL) as the example again – and the earnings estimates that we discussed in Checklist Item #8. (Remember, get there by going to the quote page and then clicking on “Analyst Estimates”in the left rail on Yahoo! Finance). The EPS forecast — that is “earnings per share” projection — is $47.76 for 2013. Divide the current share price of $556.40 and you get a little more than 11.8.
See how that works? Good. Because here’s a shortcut:
You can find that 11.8 ratio easy as pie on the “Key Statistics” page of Yahoo! Finance, too … but it’s important to understand how to do the math so the metric itself makes sense.
It’s also worth noting again that future estimates should be the basis of your P/E analysis — otherwise you’re using old info.
What the Ratio Means
A decent P/E is in the ballpark of 12 to 15, based on historic S&P 500 averages — with anything less than 12 hinting that Wall Street hasn’t caught on to the earnings growth and anything higher than 15 indicating that investors are already bidding up the price in anticipation of future growth.
In other words, a stock with a low P/E can “correct” itself by seeing an increase in share price. By practical example, if XYZ Corp. is trading for $50 and is forecasting earnings of $5 per share, it has a P/E of 10 when you do the math — but if shares somehow rose to $60 by the time those 2013 earnings come out, you now have a more typical P/E of 12 when you divide the share price by $5.
Of course, the other way to make the math work is if earnings fell to $4.20 and the share price stayed flat at $10.
Price-to-earnings is a great equalizer because stocks naturally post wildly different earnings and are valued at wildly different dollar amounts. By tying the price to the earnings, you have a pretty universal valuation metric.
So long as you use future earnings estimates, that is. The look at future earnings helps you predict future share prices.
Disclaimer: Low Is Not ‘Good,’ High Is Not ‘Bad’
Now that you understand the math, it’s important to acknowledge that sterile calculations alone can’t pick a winner. The reality is that some stocks always will have a low P/E and a languishing share price. Other stocks will have a nosebleed ratio as high as 50 but never crash.
That’s because valuations greatly vary from sector to sector, and from large companies to small companies.
Take a biotechnology stock banking on a patent approval for the FDA, for instance. Its current earnings might be abysmal, and there might be no concrete proof of future profits yet. But investors are speculating on instant success once a new drug hits the market. These stocks often can have ridiculous price-to-earnings ratios — or sometimes not even have one because their “earnings” actually are losses incurred during the research phase before any revenue stream is created.
On the other hand, many bank stocks right now trade with a single-digit P/E ratio. That’s because investors are afraid their earnings could evaporate because of mortgage write-downs or regulations that restrict profits. There is too much uncertainty, and some of these banks could lose you money despite the “bargain” valuation.
Then you have the very different nature of a fast-moving startup and a mature company that is entrenched but with only modest growth. You can’t compare the growth or valuation of those companies in the same way.
Here’s the only thing that really matters: comparisons of like businesses within the same sector. If you compare a high-growth semiconductor stock to its top competitor, or if you compare two small retail stocks, you’re in good shape. If you compare a retailer to a tech stock, however, you’re not going to learn much.
Generally speaking, lower is better. But always make sure you take the pulse of some competitors to get a measure of what a fair P/E is for the entire sector.
Wondering who the competitors are? Well, just type your prospective company’s ticker into Google Finance. The quote page will display a list of related stocks below — and you can sort them by size to make sure you’re comparing apples to apples.
There’s even a handy-dandy column for P/E! But make sure you’re comparing stocks of similar size and operations even if they are in the same sector.
Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.
Also, for just 99 cents you can download Jeff’s e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”
You can also buy a printed copy of “The Frugal Investor’s Guide” for $15.10 via online publisher Lulu.