Is that Stock Cheap or Expensive? Understanding the Power of PE Ratio

An old joke on Wall Street is that a famous investor was asked what he thought stock prices would do in the near term.  His answer was that they would “fluctuate.”

The truth is, no one can accurately predict what stock prices will do over any given day or week.  In the rare times that one knows the market will rise (such as eternal peace has been declared) or will fall (such as when a major scandal happens), while one may be able to predict the rise or fall, one cannot take advantage of this information.  By the next time stocks trade they will start out at the higher or lower price.  Think about it — if you found out that your house was sitting on a mountain of gold, you wouldn’t still sell your house for 5% more than you paid for it, you would sell it for the value of the gold.  Likewise, the investor who owns the stock you want to buy will sell his stock at a price that factors in the earnings surprise or other news, not at the price before the news was released.

There is a theory called the “efficient market theory” presented very well in the classic investing book,  A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing, which is a must-read if you’re serious about investing.  This theory says that stocks (and other assets) are ideally priced at all times, such that any news that has been reported is instantly factored into the price.    This is similar to heat conduction theory in engineering.  Those who know the laws of heat conduction will tell you that the equations predict that if you apply a torch to the end of a long steel rod in New Mexico the increase in temperature will instantly be felt everywhere, even if the other end is in New York.  Of course, this is not actually the case, but the heat applied will be felt everywhere it really matter very quickly.  In stocks, while there are sometimes some pricing discrepancies, most of the news that exists is very quickly priced into stocks.   There is no blue light special.  You, therefore, are not going to be able to run out and buy some shares after some good news comes out about Google and expect to make a big profit.  Everyone else knows the news too.

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Note however that the news is filtered through investors perceptions of what it will mean to future earnings.  And why do earnings matter?  Because the more a stock earns, the higher the potential dividend the company can pay.  The higher the future dividend, the greater the return the investor will get on his/her money.

Investing 101: 

  • A dividend is a portion of the profits that a company pays out to shareholders.  Most companies pay dividends four times per year.  To collect a dividend, all you need to do is own the stock on the day they declare the dividend.  The company will then either send you a check or deposit the money in your brokerage account.
  • Earnings are how much money a company makes in profits each year, which equals the money they take in minus the expenses they have. Earnings are often calculated in earnings per share, or EPS, where the total earnings are divided by the number of shares the company has issued.  You can find EPS in several places on the internet.  If EPS is increasing each year for a decade or more, that is a really good thing.

(For some of the basic definitions of investing terms, check out:
The Wall Street Journal Complete Money and Investing Guidebook (Wall Street Journal Guides or pick up a copy of the SmallIvy Book of Investing.)

Because companies will be expected to eventually start paying dividends, stocks rise and fall based upon the size of the dividend the company will be able to pay in the future, even if it does not yet pay a dividend.  Here’s why:

Let’s say that an investor owns shares of a company that he paid $1000 for that pays a $10 dividend each year.  He will then be making a 1% return on his investment from the dividends alone.  If he could put the money in a bank account and earn 1%, he would do so because it is riskier to be invested in stocks.  He could lose money if the company starts losing money or if stocks, in general, go down in a bear market.  The dividend might also be cut if the company stops making as much money.  A bank account is pretty much a safe bet where losing money is very unlikely.  People would only invest in the stock when the price fell far enough that the return from the stock dividend was substantially higher than the return they could get in a bank account.  Perhaps the stock price would drop by 80%, down to $200, such that the stock would then be paying a 5% return, compared to the 1% people could get in the bank.

Let’s now say, however, that the company that was paying out $10 in dividends each year is not making the same profit each year, but is becoming more profitable.  Because they are making more money, they are able to pay out a larger dividend each year.  If the company continues to be profitable and the dividend is increased each year by 15%, at the end of about four years the company will now be paying out about $20 per year, or about a 2% return if it was still a $1000 investment.  If the stock was at $200, it would be paying out a 10% return.  If you could still only get 1% in a bank account, people might be willing to pay more for the stock since that 10% return would be very tempting.  They might bid the price of the stock up to $400, such that they would be getting a 5% return, which is still a lot better than the 1% they could get in the bank.   (Note, the percentage return that you get from a stock as a dividend is called the yield.)

Now as I’ve said, investors use news and history to predict not what the dividend yield is, but what it will be in making their decision of what to pay for shares of a stock.  If a company is making earnings of $4.00 per share, once it stops growing and buying new equipment and properties, it can be expected to start paying out about $4.00 per share in dividends.  The price will then move up to the point where the yield is considered reasonable.  “Reasonable” is based on various factors, including how safe the dividend is (if a company’s earnings are always changing, such that the dividend may be cut, the stock will be priced less), what dividend other companies at the same level of risk are paying, and what the yields of other investments such as bank accounts and real estate are paying.

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Because the potential yield is based on the earnings, and because the price will move up or down based on the potential yield, the ratio of the price divided by the earnings, or “PE ratio,” is a commonly used factor to determine the relative price of a stock.  If the price is high compared with the earnings, such that the PE ratio is high relative to that of other stocks, then investors expect the earnings to grow faster than the market in general, such that the eventual dividend will justify the higher price paid.

The risk you’re taking, as measured by the predictability of earnings, as well as the potential for a company to increase how much they make each year is relatively equal for companies in the same industry.  Because of this, the PE ratio of competitors in the same industry will normally be about the same.  For example, Coke and Pepsi will have about the same PE ratio.  In addition, companies in one sector of the economy (technology companies, banks, food makers, clothing retailers, etc…) may have different average PE ratios than companies in another sector.  For example, companies that sell computers may have a higher PE ratio than mining companies.  This is because technology companies are growing rapidly at this time, while mining companies are fairly stagnant once a mine gets going, so future earnings can be expected to grow more rapidly for computer companies than for mining companies.

Also, there may be one company in an industry that has a higher PE ratio than its peers.  This is called “selling at a premium,” and usually indicates that investors expect that company to grow faster than its peers and take market share away.  This is sometimes called “best in breed.”  Companies that hold that position are not a bad investment to make.  An example was Microsoft in its hay day or Google and FaceBook today.  The trick though is to know when to get out, since when earnings stop growing faster than the sector norm the price normally falls to cause the PE ratio to fall to the sector average rather than the price holding still as earnings increase.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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