Stock prices are overrated. PE ratios are what really matter. A PE ratio is the ratio of the earnings per share divided into the stock price. PE ratios give you the best tool to measure your stock value because it separates the price from the value and stock prices can be deceiving.
Stock Price and Market Capitalization
A stock price, what the company is trading for on the market, is a function of the present value of future earnings. In other words, the stock price is future value discounted back to the now. When you buy a stock you are betting that the future value less growth over time is what is worth today. The price takes into consideration the future dividends and compounded capital gain to get to this number . So when you buy a stock you are betting that the future value will be greater than the present value.
One problem with stock prices is they fail to reflect overall market capitalization. Market cap is how much a company is worth, the true value of the company. To calculate this number you take the number of shares outstanding times the share price. Market cap allows the investor to see that a stock that is priced at $100 like Nvidia (NVDA) could look like it is worth more than a stock that trades at $15 like Bank of America (BAC).
The difference is that the market cap (price times outstanding shares) of Nvidia = 49 billion and market cap of Bank of America = 217 billion. So a stock that trades for $100 can actually be worth less than the stock that trades for $15. On the other hand, there are penny stocks that sell for $15 or less and their market cap pales in comparison to both companies. This is why stock prices can be confusing. A low price doesn’t indicate a bargain and a high price doesn’t make a stock expensive.
The PE ratio, or price to earnings ratio, is the price of a stock (P), divided by its earnings per share (E), to get the (M) or the multiple. The reason to use the price-to-earnings multiple is that it will provides an apples-to-apples view when comparing different stocks to each other. This is because every company has a price and every company reports an earnings number per share which is the net income divided by shares outstanding. This EPS takes away the market cap problem because we divide the earnings by total shares outstanding and then only look at each companies multiple.
Comparing PE ratios is like comparing similar home sales (comps) on a price per square foot basis. It just breaks down the data to help you make a sharper decision.
Using PE Ratios in Analysis
The PE ratio comparison comes by looking at the average PE per sector. So the next step is to calculate all other multiples for each, or most, stocks in your sector. Sectors are groups of stocks in the same industry such as energy, tech, athletic apparel, etc. This comparison allows you to see how your individual company matches up with other companies in the same line of businesses. If your stock is lower than the average there may be room for growth. If your company is trading higher than the average in the sector it might be over valued and poised for a pull back. This is seen in our holding of Under Armour which trades at a multiple of 44 when compared to Nike which trades at a multiple of 23. The apples to apples comparison could indicate that UA is overvalued.
However, since UA is a growth play (Netflix has a 320 PE Multiple which is booming) with a great pipeline we believe that the earnings will continue to grow the bottom line. That bottom line will increase the earnings per share and lower the price to earnings multiple. In order to bring the multiple in line you can either lower the price or increase the EPS number.
This quick post is merely aimed at giving you one more tool in your belt to use in your analysis. Yes you can still look at the price action and movement of the stock. Yes you can look at moving averages and trend lines. But the more tools you have the better house you can build. If you want to continue to learn more about investing you should join our investment club. Email firstname.lastname@example.org for more information.