The famous investor and mutual fund manager, Peter Lynch once said that if you can't explain to a ten year old why you own a company's stock, you shouldn't own it. In the same vein, he also added that if you are prepared to invest in a company, then you ought to be able to explain why in a simple language that a fifth grader could understand and quickly so the fifth grader won't get bored.
Valuation has to be no different. The estimation of whether a common stock/stocks, outstanding shares or number of shares outstanding are all undervalued or overvalued can be made as simple as possible so that a common investor is not scared away from finance and that is what we aim to do so here at fairvalue.
If you have followed our series on value investing from the start, welcome back to a new episode in the series. If you are new here, we suggest you revisit our series of articles to fill in certain gaps in our explanation that may occur here. Having said that, strap in and lets begin the ride.
Value for a stock market investor or any investor willing to invest in various asset classes is the monetary benefit derived from its investments. Logically to derive the worth of your investments, you must be willing to pay a certain amount that will be less than the worth derived for you to make a gain. No one would be willing to pay more than the current worth derived except for those that indulge in short term trading and for them the concepts tend to be little different.
Current market might be crazy behind joke stocks but historically, stock market where a company's stock is traded tends to prefer value and earnings per share, earnings growth, net income, future earnings and a company's earnings stability over anything else.
Timing the markets is a statistical impossibility and the success in joke stocks depends on the timing. Get in at the right share price and you will make money, get in at a wrong share price and you will lose money. In fact, money made on one meme company's stocks might be lost in another one.
A company that thrives and maintains it growth rate on the company's fundamentals alone will survive and succeed. Companies that fail to follow this basic financial principle tend to pay penalties and meet an early demise.
No price is to high or low in this chase as long as investment worth is received. A stock trading at $1 per share might be overvalued and a stock trading at $100,000 per share might be undervalued. Past analysis is one thing but one cannot rely on past. It is the future we must look at which is the deciding investment factor and all of the above is captured in value.
A myriad of financial ratios exist, both simple and complex which on their own may signify different meanings but whose consensus helps determine the market value of the company's stock. Several such share ratio calculator are available on our websites itself and will allow you to calculate them with relative ease.
Alternatively our premium membership does all the hard work for you providing you with financial ratios. Ratios can tell if a stock is overvalued or undervalued and we have the ratios to do just that. However investments are supposed to be simple and so we would like to introduce a ratio that is so simple in its calculation that one can figure out the company's valuation status in minutes and that is the price to earnings ratio or price earnings ratio as it is called. It is also known as p e ratio/ p e ratios or even earnings ratio p e and by variety of other names.
The price to earnings ratio or p e ratio is a simple ratio which is used to determine whether the stock price under consideration is overvalued or undervalued. A share p e ratio on its own won't tell you anything but when compared with other companies in the sector, one can determine whether it is something investors are willing to pay for or something that investors are willing to ignore.
This relative comparison with other companies makes this and other financial ratios relative valuation metrics. This relativity means that on its own, a p e ratio or price earnings ratio p has no meaning. Although a low p e ratio means undervaluation and high p e ratio means overvaluation, the context for the same is comparison with others in the industry.
A low p e ratio of say 3 or 4 might also mean overvalued and a high p e ratio might mean undervaluation when compared with companies in the sector. A company's p e ratio drives the stock price and vice versa with earnings per share eps and price per share earnings along with future earnings proving to be key influences.
Earnings per share p e ratio as we know it is given by the following formula:
Alternatively if you multiply both the numerator and denominator by the number of shares that a company has, it can be given by the following formula:
The price earnings ratio formula or simply price to earnings at its essence measures how much market price one is willing to pay for a unit of company's earnings. For e.g. a share price of $ 1,000 and an earnings per share of $ 100 has a trailing p e of 10. Trailing p e because it is based on historical earnings.
If the same p e ratio was calculated on estimated future earnings than it would have been called forward p e. Future earnings will play an important role in determining future worth of stock which we have covered in another article.
Nothing hits better than providing proof of what we are talking and to explain this let us look at your favorite superstores Walmart, Target and Costco Wholesale.
All the three companies are US based chains of super stores with businesses around the world. This tend to be cash rich and have significant profits to their name. Based on their share price alone, it would be difficult to determine which is undervalued or which is overvalued. For e.g. Walmart has a share price of $147 per share and Target has a share price of $264 per share.
From the first look, it would look like Walmart is cheap as compared to Target but what is cheap might turn out to be very expensive for investors and their investment.
The p e ratio or price to earnings ratio of all the three companies as well as industry average are presented above. All of this values can be computed by you using our free calculators or if you are a premium member, can have readily available on your premium dashboard.
As one can see the price earnings ratio or price to earnings ratio for Target is half that of industry average whereas that of Costco is above industry average. Walmart sits on the balance, at the average. This means that investors in Target are willing to pay $18 per $1 dollar of profit to make an investment whereas investors in Walmart are willing to pay $35 for that same $1 dollar of profit.
As investors, you investment will succeed when you pay less per dollar of profit. Assuming that the earnings growth rate remains 0 and the companies make the same profit every year. Investors in Target will make back their money in 18 years whereas investors in Walmart will make it back in 35 years. Now it makes sense to invest in low p e stocks vs high p e stocks and totally avoid higher p e stocks.
Price to earnings ratio or P E Ratio tends to be affected by either a change in share price or earnings and their growth rate. The following table will highlight the requisite relationship.
The undervaluation and overvaluation comes into play in returns. Let us have a look at the returns of the same three companies.
As one can see, Target which was undervalued has given the best performance in the last one year. Walmart whose valuation was in line with industry average has given a relatively poor performance and Costco has done slightly better. Costco Wholesale had high growth and higher earnings which tend to affect stock price differently and this growth calculation is one of the limitations of price earnings ratio p as we shall see subsequently.
There is a lot of potential for futher increase in the market price of Target because despite its earnings remain the same, a mere rerating of the low p e ratio to high p e ratio as per industry will double the stock price.
The market price or market value to be paid for a stock is determined by the price earnings ratio or p e ratio. Negative p e is to be avoided at all costs. A negative p e occurs only when the company makes a loss and a loss scenario is something you are looking to avoid anyhow. No one has become wealthy investing in loss making companies. If there is something you can take away from all of this, it is to avoid negative p e stocks like the plague or in our case COVID-19.
Price to earnings ratio must be in balance to the industry average. It should be less for undervaluation but not too less. For example a companies with p e ratios of 10 or less in an industry where average is 50 are problematic companies. There must be inherent issues in the company which has translated to the company's p e. Avoid at all costs. Also some of the drawbacks that must be kept in mind with company p e ratios are below.
Price earnings ratio has a big drawback that strikes a strong contrast to the current investment scenario. It tends to overvalue growing companies. Companies with a strong growth will have strong earnings per share which in turn will make the earnings ratio p e very high. This is because of current earnings and future earnings. Once the earnings growth is realized, the stock becomes undervalued but at the moment it gives an incorrect picture and must be adjusted for.
P E ratio tends to ignore cyclicality of net income in cyclical business. A cyclical company will have high earnings per share at the top of the cycle and thus low p e ratio which will make it undervalued on paper but technically overvalued as it is on the top of the cycle. Trailing P e ratio or earnings ratio p e becomes an unreliable metric in determining stock price in cyclical industries.
One can acquire our premium membership for as low as 7,9 Euro per month which allows you access to the premium dashboard where one can visit sector analysis tab to get color coded analysis of various sectors.
One can then drill down to the sector to look at the leader company and subsequent potential leaders which can then be explored to build a consensus on fundamental analysis.
p e ratio or pe ratio is a quick to calculate and easy to understand relative valuation metric that can help analyze companies and shortlist those that are undervalued for investing purposes. However this is one of many relative valuation metrics and ideally one must build a consensus of several other valuation metrics in order to truly determine undervaluation or overvaluation. Remember in case of pe ratio, earnings per share are important and current earnings tend to have lower impact on business than forward earnings.
In our personal experience, pe ratio is a pretty nifty tool to shortlist companies fast. Higher p e companies are immediately eliminated leaving you with a smaller haystack to find the needle in and that ease and comfort is what we at fairvalue aim to provide to our premium members. So welcome to our premium member club where you can relax and rest easy while we do the investment analysis work for you and you can simply take the decisions that matter while we do the hard work for you.
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