The P/E

No, I'm not talking about Phys Ed. As exciting as those high school hours playing softball or dodgeball were, it is unfortunately not the subject of this post. The P/E we refer to now is the Price-to-Earnings ratio. We never said there wouldn't be math at TLRB.

Acquaintances always seem to ask me what I think of this or that stock. As a rule, I generally try to avoid talking about individual companies or someone will take it as "tip", do something stupid on their own, and then blame me. Yet something like this is all to common "I was watching Cramer and he said blah blah blah about XYZ, but the stock is at like $80- that's just too expensive."

The problem here is the definition of "expensive". The American Heritage Dictionary says expensive means "marked by high prices; costly". Fine. Compare a stock at $80 (per share) with one at $25 and it fits the definition of "expensive". However, this definition of expensive does not take into consideration the value received for that "costly" outlay. For example, one can buy a car for $60,000 or a car for $5,000. Certainly the $60,000 car is "expensive" compared to the $5,000 car, but you would assume that the expensive car gives you some value that cannot be had for $5,000. Perhaps the expensive car is a Lexus LS 600h which retails around $100k, but since this one has 2,500 demo miles on it, the dealer will part with it for just $60k. Sign me up, that's a bargain right? Wait, didn't we say it was "expensive"? How can something be both expensive and a bargain at the same time?

Enter the idea of price for value- the price alone says nothing of how much value you receive in exchange for that price. When you buy a share of stock, you are buying a proportional piece of ownership in a company. Not only does that share entitle you to vote on company matters, but it entitles you to 1/(total shares outstanding) of the assets and profits of the company. The whole reason you invest in a company's stock is to secure rights to that stream of profit.

Let's say you walk into your local bank and buy a CD (certificate of deposit) at 4% for one year. You fork over $1000 and at the end of the year you get back $1040. Your earnings are $40 on capital of $1000 or 4%. Another way to look at this is to say for a price of $1000, I get $40 in earnings or 1000/40 or a price to earnings of 25x. Say the bank across the street offers 5%. That equates to a P/E of 20x. A lower P/E ratio means you get more bang for your buck.

Companies earn money (hopefully). They report how much they earn in Earnings Per Share (EPS). So if a stock is trading around $80 and the company earns $4 per share, the P/E is 20x. Compare that to another company trading at $25 but earning just $1 and the P/E is 25x. You can see how the price being "expensive"- $80 or $25 - has nothing to do with the value received in return. Yet people will keep making that remark that the "good" company is just too expensive. My response is always the same- "just buy fewer shares".

Before you run off to buy the companies with the lowest P/E ratios, I have to tell you that isn't the whole story. There are good reasons why some companies trade at high P/Es and some trade at low P/Es. Remember that CD with a 4% return or 25x P/E? Well that income stream is guaranteed whereas a company's earning are not. But a company's earnings are supposed to grow over time- maybe $4 this year, $4.50 next, and $5.06 after that. So the P/E on year one is $80/$4 or 20x, but next year it falls to 17.8x. Theoretically, the P/E should remain the same, all else being equal, so the stock should rise to $4.50 x 20x = $90. Because the risk is higher on the stock compared to the CD (earnings could go down or even lose money), one should be willing to pay less for the same dollar of earnings, hence a lower P/E (20x vs 25x on the CD in our example).

Of course, all else is never equal. Some companies are in businesses that just don't grow much. Some companies grow very fast and investors are willing to pay very high P/Es on the assumption that the growth will be faster for longer than other's expect. Another example would companies in very cyclical industries. Take the auto business for example. It is highly cyclical in that when the economy slows, so does sales. With enormouse fixed costs and long inventory cycles, that means they will earn a whole lot less in some years and more in others. Intead of earnings growing each year by some reasonable amount, a car company might earn say $10 per share one year, $2 the next, $15 the year after, and lose $1 the following year. If the stock price stays at $60, the P/E will bounce around from $60/10= 6x to $60/2 = 30x to 4x, etc. Obviously the P/E is rather useless in this situation.

There are other ways to value a business such as price to book, price to sales, return on equity, return on capital, free cash flow, etc. Taken as a whole, these metrics help an investor "value" a business (stocks should be considered businesses not pieces of paper, unless you are a trader instead of an investor, but that's another discussion). All these financial measurements might cause you to think that investing is a scientific, data driven, number crunching exercise. It is to a degree, but then one has to take into consideration other factors such as the likely future of the economy, political influence on the economy or business and other trends (demographics, consumer tastes, etc). This is where the processing of data is not necessarily systematic or scientific. Art and skill enter the equation. For example, should shifting consumer tastes have more influence than the slowing economy in the buy/sell decision? Without continuing into related, but a lengthier topic, I leave you to think about valuation.