The score will take care of itself ~ Bill Walsh

11ish Investing

What is the PE ratio and how do you use it

A few days ago, I was hanging out with a couple of friends and we were talking about their current investments. One of them mentioned a company I’ve never heard of, with a stock price of around 300 dollars apiece. I instinctively said that’s pretty expensive knowing full well that I meant compared to a gallon of milk expensive, it really has nothing to do with expensive or cheap in the retail sense. In the investment world, it’s about whether a stock price is overvalued or undervalued. 

 

This does remind me that time and time again, people keep asking me to talk about sub-1 dollars stocks because it’s cheap and so in this video, we’re going to talk about what P/E and P/S ratios are so that you understand what they mean and how to leverage them to help you identify sound investment opportunities. 

 

 

Literal definitions:

P/E Ratio equation courtesy of investopedia.com

 

P/E ratio or Price to Earnings Ratio represents a company’s earnings per share divided by the current share price. And a company’s earnings per share (EPS) describes a company’s profit per share of stock, which is usually calculated quarterly. 

 

 

For example

E/S Ratio equation courtesy of investopedia.com

if Apple released their quarterly earnings, stating that their Annual EPS is 3.28 and their current stock price is 121.42, then their P/E ratio is 37. Whereas, their quarterly PE ratio is about 37. If you want to compare one blue-chip tech monopoly to another, then you might look up Google’s PE ratio, which is at 35.78, and MSFT’s 34.53. This tells me investors are slightly more optimistic about Apple’s performance than MSFT’s. This also tells me that MSFT is potentially undervalued, because if I think MSFT is about to announce something amazing and it has the potential of moving investor sentiments closer to the average, then it might hover closer to at least 36. If my hypothesis is right, then 36 * MSFT’s current EPS = ~240 bucks a share, which is about a 10 dollars per share upside, or about a 4% gain opportunity.

 

Another way you should think about the P/E ratio is that it’s telling you how much investors are willing to buy or hold on to a stock, relative to how much the company is making money with its capital. If the stock price is high even though the EPS is actually low, then investors are really optimistic and potentially OVERLY optimistic, and that’s what it means when a stock is overvalued. 

 

Note that stock being overvalued has to do relative to earnings. Henceforth, a stock can BE overvalued if the price is 10 dollars or a thousand dollars. A stock can be undervalued if the price is 10 dollars or a thousand dollars.

 

Now exciting new companies that are focused on growth will rightfully NOT be profitable, because they’re spending all of their money and more growth. So if the EPS is negative, then there is no PE Ratio to look at. This is usually when you look at the P/S ratio.

 

In the next video, we’ll talk about what to do when there is no PE ratio

 

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In Summary 

A low share price does not mean the stock is cheap, and the high stock price does not mean the stock is doing well. Use the P/E Ratio and P/S ratio 

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