The Amateur Investor Ep. 9: Doing the Maths – PE ratios
A large part of stock investing is valuing. In long-hold investing, this is doubly important. Going back to the maritime analogy in my last article, imagine day traders are jet skiers and long-hold investors are early 19th-century sailing ships. The former makes infinitely more agile trades, whilst long-holders tend to make plays that take considerably longer, typically two years or longer. In both cases, being able to make informed investments is vital. It takes out a lot of the guesswork which in turn insulates you from making moves with your emotions rather than your research.
In the course of my research, which involved many long hours chatting with Hsuan, I gathered that there were a few common valuation methods and measures that should be used to measure a company; PE (Price to Earnings Ratio), DCF (Discounted Cash Flow), and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). They sound really technical, which they are. If you’re as new to the game as I am, your brain probably backfired a little, so I’m going to take it really slow for your sake and mine. Over the next few weeks, I’m going to tackle each of these metrics one at a time as best I can. If I misrepresent a little, I’m sure my fellow Mockingbirds will correct me, if not, feel free to send us an email.
In simple terms, the PE ratio measures the current share price of a company, in relation to its earnings. Other terms for it are the price multiple, or the earnings multiple. This one is relatively simple to understand, I think.
PE Ratio = Share Price/Earnings Per Share
The share price should be easy to find, it’s right up front when you look at the company on your Commsec platform (or whichever trading platform you choose). The earnings per share, on the other hand, I found a little trickier. It should be located under the company’s historical statistics, in their Earnings section. It can also be calculated if you take a company’s reported earnings in a year and just divide by the available shares (I think, I could be getting this entirely wrong)
High PEs indicate that investors expect a high level of earnings and strong growth in the future
So the opportunity is that it’s a great company and it continues to be great. The risk is that it fails to meet the expectations, and the PE drops, causing you to lose a lot of money.
Low PEs indicate that investors don’t expect much in terms of earnings or future growth.
The opportunity is that the market has missed something, and the company beats the low expectations, causing the PE to expand/grow. The risk is that the company is never going to get better and the earnings (and consequently PE) just stay flat.
Now like you, I was hoping to get a clear statement on good or bad PEs, but that is not the case. It all depends on the kind of investor you are. Some prefer a high PE since it indicates an expectation of high earnings and good growth (who wouldn’t want that?). But as I’ve learned, one of the things many veteran investors look for are companies where the stock is undervalued, but the management is sound. High demand for stock will result in a high PE, so chances are if you think it’s a good investment, then so does everyone else. Granted, if you can get in really early and buy a position before everyone else figures out it’s a good idea.
And that’s where the low PE companies come in. Share wise, they’re priced cheaply. But then you have to ask yourself why that is the case? Will it outperform? That’s where you have to do your research and figure out if you have the goose with the golden eggs, or just a regular goose (geese are really mean).
Does your head hurt yet? Mine sure does just from writing this.
Let’s look at a simple analogy. Think about thrift shopping. I like it, I do it on occasion with my brother. What you basically want, is to find a steal. You want the real leather jacket from Tannery West priced at $30, the Omega Seamaster priced at $10, or the Civil War-era furniture in perfect condition in the bargain section. Unrealistic, I know. But those things exist, and much like in thrift stores you just need to know where to look, but more importantly how to know it when you see it.
Not all companies with a low PE are bargains. Sometimes the Rolex you think is genuine is really a knock-off, well made, but still a knock off that will get you laughed at if you go in to high-society functions and tell people it’s genuine. PEs below 5, might be worth avoiding since it basically indicates that everyone and their mothers think the company isn’t worth much at all. But it might, and that’s the intangible part of it.
Conversely, a company with an outrageously high PE ratio might mean that there are high expectations for the company, but it might not perform in line with those expectations. But it might.
Now let’s throw a bit of a curveball in here and look at forward and trailing PEs.
Before you throw up your hands in surrender, it’s not all bad. Trailing PEs are just PEs calculated for the past, which all PEs realistically are. Forward PEs on the other hand, are just PEs calculated based on forecast numbers, which you can get from the company’s financial reports and other third party analyses.
I’ll point out here that PE ratios are not the be-all-end-all of stock valuing, but it’s a good starting point. It gives you a good idea for how investors feel about the company and its future prospects, but it’s just one piece of the valuation puzzle. Without the other metrics (EBITDA and DCF), you only really know how the market feels about the company. It is also worth doing a little bit of research and sleuthing on the side to see how the company is being run, what they bring to the market and all that other qualitative stuff.
Please don’t take just this article as the Gospel. Do your homework on valuation, widen your field cause like it says on the title, I’m just an amateur, fully prone to oversimplify and get things wrong. Next week we’re going to look at DCF and look at some more complex tools for valuation. If you want to pursue this further, check out the list of articles below, take some notes and try to come to your own conclusions.
And above all, play small, go slow, learn the process.
Editing credits for this article go to Hsuan and Bill, who took the time to put in comments and make sure I didn’t make more of a fool out of myself.
Further reading
