P/E Ratio, better known as price to earnings ratio is simple to understand.
The standard definition is “The ratio between a stocks current share price, to it’s earnings per share (EPS).” In short you are dividing the current price of the stock by the amount of money the company makes a year.
Don’t exert too much energy trying to remember HOW to calculate the P/E Ratio of a stock. Most financial websites will list the P/E Ratio when you enter the stock symbol.
Focus on what the P/E ratio means to you as the investor!
As always investors should view themselves as business men and women. And therefore always try to acquire the best businesses as cheaply as possible.
Imagine that you are wealthy investor and are looking to purchase a NBA team. In fact you would like to own the Miami Heat, after all they did just win the NBA Finals.
You do some digging and see that after everything is said and done the Miami Heat as an organization makes 1 Billion dollars a year. Fantastic! Who wouldn’t love to make 1 Billion dollars a year while sitting back and watching Lebron James.
Your next step is to approach the current owner and ask him what he’s willing to sell the team for. After careful consideration he looks you in the eye and says, “I’d be willing to let go of my precious team for $10 Billion.” You thank him for his asking price then ask him for a moment while you think it over.
Now in your head you consider the fact that you’re a 45 year old billionaire and you assume that you will live to see at least 70 — giving you an investment horizon of approximately 25 years — so if you purchased the Miami Heat it would take you 10 years to earn your initial investment back, then every year after that you’ll enjoy $1 billion of income. And who knows, maybe you’ll find a way to grow the team and make more than $1 billion dollars a year, but lets assume that the team will only earn $1 billion for educational purposes. That’s a great deal if you ask me!
Now take the same exact scenario and visualize instead of asking for $10 Billion the current owner asks for $30 Billion for the Miami Heat.
Your eyebrows immediately jump in amazement because you compute the math in your head and figure out that it will take you 30 years before you get your initital investment back. You think to yourself “Heck I’m 45, i’ll be 75 before I get my investment back, I only plan to live up to 70, every year after that is pushing it. You also consider the fact that you could improve the business and see that you may even be able to raise the yearly income from $1 billion to $2 billion, but even still that leaves you with having 15 years until you get your initital investment back and doubling your profit is no easy task.
At this point you consider $30 Billion a ridiculous price for the Miami Heat, even if they do have Lebron James and great weather during the winter. So you politely decline.
A couple days later you hear about a gentleman from Texas who is 60 that bought the team for $30 Billion. You shake your head at the news and just hope he lives to see 90!
So what is a real world example of this in the stock market? I will give you two.
Back in July of 2010 Abbot Laboratories (ABT) was trading for approximately $43 a share and had EPS of $3.71. That worked out to a PE Ratio of roughly 11.5. Take a look.
Investing at a P/E Ratio of 11.5 indicates IN THEORY that it should take you approximately 11 and a half years to earn back your initial investment.
Take a look at how ABT is performing today.
In about 2 years ABT has produced a return of almost 50% and that doens’t even include dividends!!
Back in July of 2011 Netflix (NFLX) was trading for approximately $260 a share and had EPS of $3.06. That worked out to a PE Ratio of roughly 85. Take a look.
Investing at a P/E Ratio of 85 indicates IN THEORY that it should take you approximately 85 years to earn back your initial investment. This is absolute stupidity, excuse my lack of professionalism, but there is no other way to describe it, NONE! Investing in Netflix at this price is like playing a game of hot potato….somebody is going to end up burnt.
And somebody did — take a look at how NFLX is performing today.
It took about a year and a half for NFLX to lose 79% of it’s value if you had purchased in July of 2011. Although it was a great company — A great company + A high price tag = A losing investment
Please remember that the P/E ratio metric isn’t a end all be all indicator but it is a great place to start in screening companies.