Introduction to the Price-to-Earnings Ratio

My son has been successfully subdued, so I think this is a
good time to learn about the Price to Earnings ratio.
And a lot of times you'll hear people talk about
a stock's P/E Ratio.
And it's all the same thing.
It's just a faster way of saying
Price to Earnings ratio.
So let's think about the Price to Earnings ratio of the
company in question, this widget case study, I guess you
could call it, that we've been dealing with.
Let's say that the market value-- we talked before that
the book value per share of this company is $5.
Because the book value of its equity is $5 million.
And there's 1 million shares.
So 5 million divided by 1 million is $5.
But let's say that the market price, let's say that this is
Widgets Inc. and let's say that its ticker symbol is
WINC, for Widgets Inc. And its price is, it's trading at--
let me make up a good number-- let's say
it's trading at $3.50.
And then we learned in the first video that a price by
itself doesn't tell us a whole lot.
So how may shares are there?
We know there's a million shares.
So the market cap, or what the market perceives the value of
this equity is, the market capitalization,
is these two numbers.
If we have a million shares, then each of them, the market
is saying, is worth $3.50, then the equity of the company
is worth $3.5 million.
And this is the market value of the equity, what the market
thinks the equity's worth.
So this is interesting.
In our case, the book value of the equity was $5 million.
But the market is saying, no, no, I don't necessarily
believe those accountants.
Maybe they're throwing some stuff in here that's not
really there.
So we say it's only worth $3.5 million.
In this case, the company's trading at a discount to its
book value.
And I won't go into detail on that now, but that's actually
a fairly unusual circumstance, unless people are very
suspicious about the accounting or the actual book
value of the company.
Or if they think that this is just a kind of an asset with a
useful life that has been shortened.
If you owned a bunch of video stores, then all of a sudden
you say, I have $10 million of video stores, and then the
next day someone makes on-demand videos there, all of
a sudden, maybe your assets aren't worth what you thought
they were before.
But we'll talk a lot more about that when we deal with
real examples.
But in this case our market cap is below our book value.
And you can even look at it from the price.
I said the price doesn't tell you much.
But it tells you a decent bit if you think
of things in per-share.
Because we know that the book value per share is $5.
The price per share, the market price per share, is
$3.50, so you could also say it's trading at
a discount to book.
Now, what were the earnings of the company?
Well it was making $0.35.
So let me write this down.
Earnings was $350,000 in 2008.
And let's just say we're looking this from the vantage
point that 2008 has happened.
This isn't like I'm at the
beginning of 2008 and modeling.
So let's say we're looking at this on January 1, 2009.
And let's say the company has already released its earnings,
although it normally takes a lot longer.
Probably closer to 45 to 90 days.
But let's say they released their earnings.
So we say, oh this company made $350,000 in 2008.
Or another thing that you might see a lot when you look
at companies, is that this is trailing 12 months earnings.
You'll see this TTM sometimes.
Because when someone says earnings, are those the
earnings last year?
Are those the earnings that you're
predicting for next year?
So this is trailing 12 months earnings.
And if you want to look at earnings per share, EPS, is
this number divided by the number of shares was $0.35.
So first, just to learn what the Price to Earnings ratio
is, let's just calculate it.
Then we can talk about what it actually means and if we have
time, we can have a discussion on why a company might have a
higher or lower Price to Earnings Ratio.
And that discussion can actually get quite involved.
But in this case, you literally just take the price
of the stock and you divide it by the earnings per share.
So let me switch colors just to ease the monotony.
The Price to Earnings ratio is equal to the price-- so
$3.50-- divided by the earnings per share.
Divided by $0.35.
So in this case, the Price to Earnings ratio is 10.
What does that tell you?
well there's a couple of ways to think about it.
One is, you could kind of flip this.
No-one ever talks about the Earnings to Price ratio, but
that's an interesting thing to even think about.
Because it connects it with a lot of other financial
concepts that are out there.
So this is kind of a Sal special ratio, but it's a
useful one to think about.
The Earnings to Price ratio is just the inverse of this.
0.35:3.50, which is equal to 1/10.
Or 10%.
And so the way to think about it is if you're paying $3.50
per share for this company, and let's say the company next
year-- so this is trailing 12 months earnings.
But let's say this company, for whatever reason, it's a
really stable company.
It's doing the same thing every year.
It's not growing.
It's not shrinking.
Let's say that not only is this the trailing 12 months
earnings, but this is also-- actually, I'll introduce
terminology right here.
So this is trailing 12 months.
You could also have forward earnings.
What are forward earnings?
You can probably guess.
The earnings I just said, this is actually what happened to
the company.
This was the earnings of the company last year,
or the last 12 months.
Forward earnings are, you know, there's a bunch of guys
with MBAs and CFAs working for the banks, and they write
research reports.
And they model the company.
They meet with the company.
They analyze the industry.
And if they're good analysts, they'll come up with a number.
They'll say, I think this company is
not going to change.
It's such a super stable business.
They're going to make $0.35 in 2009 as well.
So in this case, this would be the forward earnings.
And usually if it's a well-followed company, there
might be 10 or 15 or 20 analysts.
And what they do is they average out all of the numbers
from all of those analysts.
And then if the average is, let's say, $0.35, they'll call
this the consensus.
So the consensus is just the average of all of the sell
side analysts out there.
And maybe I should do a whole video on what sell side means,
but since I said the word I'll tell you right now.
Sell side are like the investment banks and the
research houses.
And the reason why they're the sell side is because they're
always selling you stuff.
They're selling you stocks.
They're brokering transactions.
They write these research reports because they want to
go to institutional investors or people who have their
brokerage accounts with these banks, and essentially sell
them stock.
Say hey, you should buy Widgets Inc, because it's only
trading at a Price to Earnings of 10.
And we really like it.
It's much better than buying treasury bonds right now,
because you're making more money on it.
You're making 10%, and that's just to connect the dots.
Price to Earnings of 10.
If it's stable, you're making the equity will grow in this
coming year by 10%.
And that's better than what you get out of treasury bonds.
So that's what sell side means.
So a sell side analyst is someone who
publishes these reports.
A buy side analyst is someone who works for a hedge fund or
works for Fidelity at a mutual fund.
Or works for an endowment or a pension someplace.
And they're managing other people's money.
And they're trying to figure out if they can
believe what's happening.
So they're going to do their own analysis.
So that's what the buy side is.
Those are the people who are actually managing money and
deciding what they want to invest the money in.
The sell side are the people who do analysis and say, hey
due to my analysis isn't this a good stock?
Don't you want to buy or sell this stock?
So fair enough.
That was a bit of a diversion.
Anyway, going back to Price to Earnings, we calculated the
Price to Earnings.
It was 10.
But the reason I wanted do to Earnings to Price is because
it connects it back to things like yield and interest. I can
do a Price to Earnings on my bank account.
Let's say in my bank account I have $100.
So this is a diversion right here.
So let's say I have $100 in my bank account.
And over a year I make 2% interest. Let's say it's
guaranteed 2%.
Maybe it's in the CD.
So I have $102 at the end of the year.
This 2% were my earnings.
So I made $2 of earnings.
So the way to think about a bank account is, well how much
do I pay for that bank account?
Well in this case I paid $100 for the bank account.
So the price would be $100.
And the earnings on the bank account in
that year were $200.
So it has a Price to Earnings of 50.
Or if you do the Earnings to Price, if you do
$2/$100, you get 2%.
Which is normally how we think about bank accounts.
We say, oh I'm making 2% interest on that bank account.
Now, this actually leads to a very interesting question.
If a bank account only gives me 2% on my money, and this
company is arguably giving me-- assuming that it's stable
and I believe the consensus-- it's giving me 10% on the
money, why would I even hold this bank account?
Why wouldn't I just pour all of my money?
Why am I willing to pay a higher Price to Earnings for
the bank account than I am for this company?
And I think you already get the sense that the lower the
Price to Earnings, all else equal-- and that's a big
thing-- all else equal, the lower the Price to Earnings,
you're paying less for something.
You want to have a lower Price to Earnings ratio
for the same asset.
Because you're getting the same
earnings for a lower price.
But when you lower the Price to Earnings you are increasing
the Earnings to Price.
So you would increase your yield.
You want to maximize this number.
But I'll finish this video with kind of a basic question.
Why would someone ever keep their money in the bank at 2%
or a Price to Earnings of 50, when they could have a Price
to Earnings of 10 with Widgets Inc.?
And the answer is because this is very uncertain.
Who knows what happens with Widgets Inc.?
Maybe all of these guys were-- Maybe this
is a big Ponzi scheme.
I mean, most companies in this country aren't.
And that's another thing to talk about, is country risk.
Because even though you're probably suspicious of them
now, the US has some of the most transparent companies
with some of the best accounting standards.
If this was in-- you know, I don't want to state any
countries because people all over the world listen to these
videos-- but if it were a country with less solid
accounting standards, you would be like, they might be
making up all of their numbers so I don't trust it.
Or you might say, you know, Widgets Inc., even though the
analysts are saying that they're going to make $0.35
this coming year, you might say, you know, I
don't believe that.
I think there's actually a lot of risk in Widgets Inc. That
there's actually more volatility here than anyone
gives credit for.
They might go out of business.
There's a strong competitor.
There's a lot of risk involved.
And the other thing is, even if you don't
think there's risk.
Even if you think that this company's going to make $0.35
forever, the other reason why you might prefer to have a
bank account over Widgets Inc. is because you're guaranteed
to get $102 back for your bank account at the end of the year
if you wanted.
Assuming this is a CD with a one year duration.
You're guaranteed to get your $102 back, especially if it's
FDIC insured.
But in this case, even though the earnings might be the
same, something horrible might happen to the markets and
everyone just dumps their stocks, money flows just run
outside of markets.
And for whatever reason people get scared, and the price
could go down a lot from $3.50.
It could be very, very volatile.
And this thing, maybe the price goes from $3.50 to $1.75
a year later.
Which it seems like a really good deal, because now the
Price to Earnings is $1.75 divided by $0.35, would now be
a 5 Price to Earnings.
But this could happen.
I mean, companies go from a 10 to a 5 Price to Earnings.
And then all of a sudden, if you want that money, if you
need that money a year later, you've lost half of it.
So there's some volatility in the price even though you're
assuming that the earnings are stable.
So that's a little bit of a taste of why someone might
realistically, in this case, pay a higher Price to Earnings
for safety.
Safety because you know that this earnings stream is
guaranteed.
And liquidity.
Liquidity because you know you're going to
get your money back.
That you're going to be able to essentially sell your bank
account and get cash for it.
And you know that it's going to be $100.
That there's no volatility in price.
Well in this case, you're uncertain about
the earnings stream.
You're uncertain about what the market will be willing to
value it at a year later.
And frankly, you might be uncertain about
liquidity in general.
Maybe this is a really small company and not a lot of
people trade in it.
And you might not even be able to find anyone to buy it a
year later.
The epitome of an illiquid asset is maybe a really
expensive $20 million house.
Even though it might be worth $20 million, a year later you
might not-- there are only so many people who can afford a
$20 million house.
So it's an illiquid asset.
Anyway, I want to leave you there.
In the next video we'll go into more depth on Price to
Earnings ratio, and think about things like growth and
stability and whatnot.