By elmads

Stocks and Shares are portions of ownership in a company. What we actually have in this ownership is the rights to a company’s earnings. When a company is profitable so as our investment with them. Henceforth, we receive dividend income and/or price appreciation of the company’s stock price.

Nevertheless investing is not just about that, because the price level we pay on an investment is also a significant contributor on our returns. This is where valuations come in, it is an estimation of a worth of a company stock based on their actual business earnings.

Take note that the stock price doesn’t completely reflect a company’s current earnings and performance. Price is different from value, if you are a stock price focused person, then most of the time you’ll not bother about the underlying company’s business operations, performance and future plans of growth. Whereas, the value type of investors are focused on the company itself rather than the price.

There are various and different valuation methods that we can do, but the fastest and easiest way is to do relative valuations. It is knowing if a company is cheap, fairly priced or overpriced compared to its peers within the industry and also from the company’s past and future performance.

Price-to-Earnings Ratio (P/E Ratio)

P/E Ratio is what links the company’s net income to its stock price. This is the most popular relative valuation method, it is for us to know if the company is over, fairly or under valued. This is computed by Dividing the Current Company Stock Price to its Earnings Per Share (EPS).

Before I go forward to P/E Ratio, we first need to understand EPS. Remember that a share is a piece of a company, owning one or more shares are proof that we have the rights to receive portions of the company’s earnings. To know more about stocks and shares see my blog titled “Stocks & Shares”.

That in mind, all earnings of a company in a specific year are computed into per share basis or know as Earnings-Per-Share (EPS).

How? Below is the formula and example of it;

Scenario; Elmads Corp (a sample made up company), had a total Net income of £500 million for the Fiscal Year (FY) 2021. The company’s total shares outstanding is 10,000,000 (10 million) shares. What is Elmads Corp’s EPS for FY 2021?

• EPS = Net income of the company / Total shares outstanding

You can find these information on the company’s most recent annual reports, or with various financial investing apps and websites in the internet, such as investing.com, wsj.com, tikr.com

• EPS = £500,000,000 FY 2021 Net Income / 10,000,000 shares outstanding

• Earnings Per Share (EPS) = £50

Note: the EPS itself is not a relative valuation method, it is just a prerequisite to arrive into the Price-to-Earnings Ratio (PE Ratio) of a company.

EPS focuses on the earnings of the company related to its company shares outstanding. The Price-to-Earnings Ratio on the other hand, tells us how much investors are willing to pay today for the company’s shares, based on their most recent earnings.

To give you context, it is actually asking this question. How much are you willing to pay for an item you want to buy? let it be a jewellery, a watch, a car, and a pair of shoes? Some people will buy things at a suggested retail price, some will just wait for the price to become lower, while others will be willing to pay more than its worth. That’s basically the same with P/E Ratio, It’ll give us the idea how much investors are willing to pay for the company’s shares, but unlike the examples I cited above, P/E Ratio is based and related on the company earnings.

Formula;

• P/E Ratio = Current Company Share Price / EPS

For example, Elmads Corp. FY 2021 EPS is £50, while the current share price of the company is £800 per share.

• P/E Ratio = £800 per share stock price / £50 EPS

• P/E Ratio = 16

Elmads Corp’s FY 2021 P/E Ratio is 16. Okay now we got that number, but what does it mean? what does it translate to? is it cheap, fairly valued or overpriced?

P/E Ratio by table metric method.

Warren Buffett, the considered greatest investor of all time, has a basic metric regarding P/E Ratio ranges. It is to quickly check its relative valuation compared to the general market.

With our Elmads Corp sample above, its FY 2021 P/E Ratio is 16. We can surmise that the stock price is at a fairly valued levels when compared to the company’s earnings. See the word I used? surmise, it means that we made an intelligent guess without doing further research about the company.

P/E Ratio by this method is just a basic metric, this is not the absolute value. Meaning, we need to consider a lot of factors before making a final judgement if a company is undervalued, fairly valued, overvalued or way overvalued.

This was made as a guide and reference. Warren Buffet himself actually never focus in this one metric, he just uses it as a reference at times, to look into where the market currently prices the company stock at, in a P/E Ratio basis.

P/E Ratio by Comparing same Companies within Industry

Another reason in using P/E Ratio, is for comparative purposes. We compare a specific company’s P/E to other companies within the same industry. If the company we are looking at is within the same P/E Ratio range as its peers, then we can say that it can be somehow at the fairly valued levels, same can be said for if it is higher or lower than the average P/E of the whole industry.

See example below;

The above photograph are the P/E Ratios at the end of fiscal year 2020 of various US semiconductor companies. If we use the comparative measures for P/E Ratios, we can say that Intel Corporation (with P/E: 10.79) at the end of FY 2020, is undervalued compared to the Average P/E ratio of the top companies under the semiconductor industry (P/E: 42.51). On the contrary, NVIDIA (P/E: 90.57) is overvalued compared to the average P/E Ratio of the semiconductry industry.

But what if we use the P/E ratio by table metric method? what will be our assumptions then?

• Intel Corp with P/E 10.79, is “Fairly valued”
• Microchip Technology with P/E 25.64, is “Overvalued”
• Whereas, the remaining semiconductor companies in the list are above P/E Ratio of 30, so that means they are “Way Overvalued”.

Historical P/E Ratio

In here, we base compare the historical P/E Ratio of a company. Most of the time we use their 3-10 years of P/E Ratio data. We get the highest, lowest and average recorded P/E ratios of the company we want to check.

Sometimes getting more than a decade’s worth of data is not advisable anymore, because technologies, macro/microeconomics and the needs of the people change, which could skew significantly our assumptions.

The above chart shows the various P/E Ratios of Apple Inc. since FY 2011 up until FY 2020, included are the 10, 5, and 3 years averages of the data given.

We base our P/E Ratio assumptions by comparing the average to the most recent Fiscal Year P/E Ratio.

So, by using the example above, it depicts that for FY 2020, Apple Inc’s P/E Ratio of 35.13 is overvalued compared to its 10, 5, and 3 years historical averages of its P/E Ratios.

Nonetheless, there is an actual problem with knowing the P/E Ratio of a company. And that is, it is a lagging metric, why is that? because the earnings we usually get are not the actual real time earnings, it is usually fiscal year’s earnings which happened already a few months back. This is because full year earnings of a company are usually disclosed after 1-3 months after finishing the year. See for example for the FY 2020 which finishes on the last day of December of 2020. The Full year reports will be disclosed by companies in January or February or even March of 2021. Some companies in other countries are more late with their disclosures, sometimes taking more than 3 months after the Fiscal Year had ended. Also, if we are already at the 3^rd quarter of the year, the previous year’s P/E Ratio is not updated anymore because it had been 9 months passed already.

To Sum it up

Price-to-Earnings ratio interprets how much an investor is willing to pay a dollar of earnings of a company. Let’s say you bought Amazon at a P/E ratio of 66, this means that for every dollar of earnings of Amazon, you are willing to pay 66 dollars for it. You’re paying $66 for $1 of Amazon earnings.

Moreover, people are confused nowadays because having a P/E ratio of more than 30x earnings is incomprehensible already, technically it’ll be like a code red in relative valuation table metrics. But, hey there are a lot of companies now who are trading not just at P/E ratios of 30x levels, some are even at 50x to 100x earnings already.

How come? well because most companies at these level are considered growth companies, just like Amazon,. They are the companies who are deemed to grow exponentially in a yearly basis, which is one of the reasons why investors are willing to pay at higher P/E multiples.

The growth investor’s mindset, is that they are paying for an undervalued or fairly valued price today for the projected income of a specific growth company in the future. So basically the price today is overvalued in the current earnings of the company, but it is cheap when the forecasted income of a growth company materializes in the future.

Always remember this, P/E Ratios are only a guide and a tool to look into, it does not have the final say in our investment decisions. Think of it as an X-Ray or blood examinations requested by doctors. It is a part of their extensive assessments, they do not solely rely on one diagnostic examination, they also consider a lot of factors including the signs and symptoms of the patient. It is a way for them to arrive into the most accurate medical diagnosis, because one wrong step could lead to a significant medical intervention disaster for the patient. That is basically what P/E Ratio does as well, it is one of the diagnostic examinations we can do to help us to have a better view and perspective in a company’s value.

See “Part 2” of this blog

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.