Investing Basics: The P/E Ratio (Lesson 1)
Dedicated to the idiot, (but lovely) girls at my home church.
1) Understanding what the Price to Earnings (P/E) Ratio Is:
The P/E ratio is most important metric you will need to know to know in the investing world. If there is only one metric you can know, it will be this. So, what is the P/E ratio?
The P/E represents the price you are paying for each $1 of earnings the company makes every year.
‘P’ = Price
‘E’ = Earnings
Hence, the ratio between the ‘price’ and ‘earnings’ is the P/E ratio.
The average P/E is historically 15x, in the stock market. The lower the P/E ratio, the less you are paying for each dollar of earnings the company makes. The higher the P/E ratio, the more you have to pay to own each dollar of earnings the company makes.
Now let me ask you:
Would a low P/E ratio or a high P/E ratio be better?
A lower P/E is better than a higher P/E, all else equal. If you are buying a stock at a 20x P/E, that means you are willing to pay $20 dollars for every $1 of earnings the company makes. If you are buying a stock at a 10x P/E, that means you are willing to pay $10 dollars for every $1 of earnings the company makes.
In this example, you can pay $20 dollars for each share of company A and be entitled to $1 of earnings every year.. However, for company B, you can pay $20 and be entitled to $2 of earnings every year. You get twice the amount of earnings from company B, because you paid only half the price of company A. That is why generally speaking, a lower P/E, all else equal is better. It’s about getting the most value for every dollar you put into your investment.
The less you pay in price, the higher your returns on investment will be. The price you pay determines your rate of return.
2) The Earnings Yield: The Yield of the E/P
Knowing how many dollars people are willing to pay for every dollar of earnings is important, but what does mean in terms of a yield?
A yield is the amount in percentage, investors get back in cash, on an annual basis.
If Pastor Joe borrowed $100 from you for five years, and he paid you $5 for every year in the five years Pastor Joe borrowed money from you, the yield (interest) you get from lending him money is 5%. ($5 ÷ $100 is 5%)
Understanding the profits you earn back every year as a percent of your investment cost in stock investments is also known as the 'inverted P/E ratio' or the Earnings Yield.
It is just the P/E ratio flipped backwards (inverted), hence, the Earnings/Price (E/P).
If a company has a P/E ratio of 20x, that means for every $20 you pay, you get back $1 of earnings every year. Since $1 ÷ $20 is 5%, this is 5% you get back, theoretically. It is only theoretically, because not all the earnings are paid out. However, the 5% earnings yield shows us the potential of what we can get back in actual cash, assuming all earnings were paid out. Unfortunately, in this complex business world we live in, sometimes executives and management of the company, squander the earnings that the shareholders are supposed to be entitled to.
Side Note: It is for this reason that, some investors prefer and only invest in companies that pay out most or all of the earnings in dividends. Some people use the dividend yield as the official real yield. (Dividends is the portion of earnings paid to shareholders as income from the company’s earnings reserves the company has.) This will be explained in the next post.
3) Stocks: The Yields That Grow
As of 2019 April, these are the relative yields from each major asset class:
CDs from banks give you 2.5%.
Treasury bonds give you 3%.
The S&P 500 Index* gives you 4.5%.**
From the yields each of the investment gives, stocks are the most attractive on a relative basis. Furthermore, the stock yield relative to the cost of your initial investment grows.
What does that mean? Here is an example:
Part 1 Review: The P/E ratio
If Company C in year one earned $2 per share, and the stock price per share was $24, what is the P/E ratio?
The P/E would be 12. (24 ÷ 2 is 12).
Part 2 Review: The Earnings Yield
Now, what is a 12 P/E? What is that in terms of a yield on investment cost?
The inverse of a P/E of 12 would mean 1/12, or 8.3%
This would mean that, buying Company C's stock at today's price would give you a return (yield) on investment of 8.3%.
Part 3: A Growing Yield
We know that company C at $24 a share, with $2 in earnings per share, will give us an earnings yield of 8.33%. (Please tell me you do.)
What if next year, Company C earns $2.20 a share? What does your earnings yield look like for Year 2?
Figure out your cost of investment. We paid $24 a share, so the cost is $24.
What is the earnings of the second year in percent amount, compared to our original cost? Earnings in the second year was: $2.20. $2.20 ÷ $24 will give us a yield of 9.1%
If earnings per share (EPS) of Company C keeps growing by 10%, what will the yield in year 3, 4, and 5 look like? Earnings per share growing by 10%: Year 3 EPS = $2.20 x 1.1 = $2.42 Year 4 EPS = $2.42 x 1.1 = $2.66 Year 5 EPS = $2.92 x 1.1 = $2.92 Yields would therefore look like: Year 3 Yield = $2.42 ÷ $24 = 10.1% Year 4 Yield = $2.66 ÷ $24 = 11.1% Year 5 Yield = $2.92 ÷ $24 =12.2%
It pays to sit and wait! The US stock market on average grows their earnings by 4%, so every year you would get a bigger and bigger yield on investment compared to the year before. 10% is a much faster growth rate and therefore, the yields get much bigger very quickly.
Bonds and CDs don't pay you bigger interest over time - What you see is what you get.
Stock earnings grow over time.
Time is the friend of those that grow, and the enemy of those that stand still.
Lesson 2 will continue more about the P/E ratio.
*The S&P 500 Index is just a collection of the United States’ largest 500 companies. Big companies like McDonald's, Amazon, Microsoft, Walmart, Boeing and many others are on this index. This is the most common way people measure the stock market performance and valuation averages (P/E ratio). When people say that the stock market is expensive, they usually mean that the S&P 500’s P/E ratio is high. (High usually means above 15x P/E)
**The S&P 500's average P/E is 22.4. What is 22.4, inverted? It would be: 1/22.4, or 4.5%. This is the yield the S&P 500 gives you today.