Hi fellow investors,
This is Charlie Tian again. Last time, I talked about the Shiller price-earnings ratio and I mentioned that it is a better way to determine valuation of stocks and the general market. Today I want to talk about a very basic concept. The P/E ratio.
The P/E ratio is very simple. It is the price divided by earnings. So if you pay $15 dollars for the stock and the company is earning one dollar per share, the P/E ratio will be 15. This gives a mirror of the amount of time it will take to earn your money back.
This means that the smaller the P/E ratio is, the faster you will get your money back. The advantage of this is that you can compare different businesses across different industries. This lets you find which company you will get your money back from the fastest and helps determine where to invest. Obviously, if a company is growing faster, you will get your money back faster.
Sometimes you will see the concept of forward P/E. This means that it is the company’s price divided by the next year's earnings. If the forward P/E is lower than the P/E, it means that the company is growing its earnings. If the forward P/E is higher than the P/E, it means the company’s earnings are declining.
There are some things to be careful about with the P/E ratio. First, a low is P/E is good, but a negative P/E is bad. This means the company has negative earnings and you are losing money. If the company continues to lose money, you will never get your money back.
Secondly, one-time earnings can distort the P/E ratio. A company could have high earnings at some point and the P/E ratio could be artificially low. This can be deceiving.
Third, the P/E ratio does not work well for cyclical companies. If you take Southwest (LUV, Financial), for example, and look at their price alongside the P/E ratio, you can see that the P/E ratio goes wild at times. During the financial crisis of 2008 and 2009, you can see that the P/E ratio actually goes negative due to them losing money. Prior to the crisis, the ratio was very high because the company was not making as much money.
The P/E ratio is very good to use when the earnings are predictable and stable. It works well for stable companies and does not work well for cyclical companies. Again, you need to be careful about one-time earnings that can distort the ratio.
Next time I will talk about the price-sales ratio, which can be a better measure at times. In the meantime, if you have any questions or comments, please leave them below and I will get to them as soon as possible.
See you next time,
Charlie Tian
