Buying Stocks? Neglect This Metric At Your Own Peril!

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When it comes to investing, the one advice that gets often repeated is: Invest in blue chip companies. Certainly better than shorting and investing in penny stocks! But how valid is this advice?

Let’s take a company that’s solid, profitable, pays dividends and has seen multiple depressions and recessions and is still going strong. AT&T. The company is so old that the last T is now obsolete! But AT&T, being a bellweather company, is regarded as a good, stable bluechip company. How could anyone go wrong investing in the big T?

Let’s say in 1999 at the peak of the stock market frenzy you bought into AT&T while your paranoid friend decided to stash his cash under his mattress. Guess who would’ve come out smiling? Not you! You would’ve lost more than 40% of your investment! Your only consolation would be, had you invested in a technology stock, you probably would’ve lost more or everything!

But then that’s not the point of investing. What went wrong? AT&T was a profitable company back then and it is a profitable company now. The answer is you simply paid too much for T back in 1999.

How can you tell if you are overpaying for a stock? Many consider the PE ratio to be a good indicator of value.

What is Price-Earnings Ratio?

PE is the ratio of current price of a share of a company to its earnings per share.

Here’s Apple’s PE ratio from Yahoo Finance.
Apple's PE ratio from yahoo financials
In layman’s terms, PE tells you the price you are paying relative to the company’s performance. The higher the PE, the more expensive a stock is.

What’s a ‘good’ PE ratio?

Benjamin Graham, regarded as the father of value investing, in his book Security Analysis says:

We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.

Today 15 or 16 is considered a fair price. But then finding good companies isn’t that simple. PE ratios differ based on the competition, sector and time period.

For instance you would be hard pressed to find a high-growth technology company trading at a low PE.

Is a stock with a low PE necessarily a bargain?

Not necessarily. A low PE could be due to the sector the company is in (utility companies historically have low PE ratios), low investor confidence in future earnings, ongoing SEC investigations and various other factors. Always research thoroughly. If something’s too good to be true, it usually is!

Back to our story. AT&T back in 1999 was trading at a PE of over 25! Even with its outrageous long distance plans, AT&T simply couldn’t live up to investors’ expectations.

Today AT&T trades at a PE of a little over 7. Is it a bargain? Only time will tell. Verizon on the other hand, is trading at a PE of 39!

Calculating PE

Here’s Apple’s PE ratio from three different sites:

Morningstar13.0
Google Finance18.76
Motley Fool23.0

How come all three are different for the same company? That depends on how the PE is calculated. PE’s can be calculated based on

  • Last 4 quarters (trailing PE)
  • Next 4 quarter earnings estimates (forward PE)
  • Combination of both

And that’s why you see different values from different sites.

PE ratio today

Warren Buffett on value investing and PE ratiosDuring the stock market boom, a number of experts started questioning the value of this metric and some went as far to say that this ratio is no longer relevant in this “new” economy.

Warren Buffett was an exception and refused to get sucked into the stock buying frenzy. When it seemed like everyone was making money in the stock market, Buffett actually said he couldn’t find any bargains. In fact, Barron’s mocked Buffett in it’s Dec. 1999 edition titled What’s Wrong, Warren?. And this is a quote from the article:

After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch.

Why did Buffett feel there were no bargains? The PE of the S&P 500 was at it’s highest ever at 44.20 at that time. The historical average is 15.

Today S&P 500′s PE stands at a little over 23.

When evaluating a stock, PE shouldn’t be the only metric to consider, but let this not be the only metric you neglect!

Fun exercise for you

Based on their PE ratios, what are your thoughts on buying into these companies : Netflix, Amazon, Chevron, Kinder Morgan Partners and Walmart.

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35 thoughts on “Buying Stocks? Neglect This Metric At Your Own Peril!

  1. I had Netflix when they first went public, it double for me and I jumped out… HUGE mistake on my part!

    I like to use the “Forward P/E” just to get an idea of the expected growth of the company too. I was in BIDU and after it went up huge for me, I temporarily jumped out because the P/E ratio was giving me a nosebleed.

    Netflix is too rich for my blood today… If NFLX has a big fall in stock price, I might take a second look though!

    • I bought Baidu right after the split. Sold it when it peaked at $110. Purely speculation – I don’t long term interest in Baidu.

      Netflix is too expensive for my taste! Buying Netflix when it went public – that’s a pretty good call! Hope you didn’t sell it soon after and managed to cash a good profit!

      • That split was nice, it really made the price of the stock increase. I’m playing with the houses money with this one, so anything goes :)

        I got back into before earnings, and then jumped out… I’m a little reckless with this one, but I already have my initial investment out…

  2. Great Post. Good point on Buffett.

  3. Price to earnings is a good metric. I like price to sales and price to book as well. When Buffett talks, people should listen!

    • The thing I like most about Buffett is that he is very humble. He always admitted his mistakes and never claimed to be a know-it-all. His letters to shareholders are a pleasure to read!

  4. Buffet simply proved that following the crowd is not always the most rewarding path. It helps to have an “investor’s instinct” to smell when a market got out of hand in terms of valuations!

    • Good point! Buffett practised what he preached – be greedy when others are fearful and fearful when others are greedy.

  5. I’ve heard its not always a perfect indicator (probably largely because the markets are not rational, which I will have to agree with having recently on my blog bought stocks based upon the advice of my dog) but thanks for explaining the P/E ratio in an in-depth and clear manner.

    • Definitely! As you correctly point out markets are not rational (if it were, we wouldn’t have had the dot com bust!). But PEs help gauge what an investor’s expectation is from a company in terms of future earnings.

  6. I think Netflix is highly overvalued. It seems to be a bandwagon stock right now. It keeps pushing higher because everyone is jumping on. I bought when it was about 40 bucks and sold at 58. Guess I should have stayed in for the hype… Nice post, we did one on ratios as well at http://www.fsyaonline.com/2011/01/time-to-get-technical-part-2.html

  7. Thanks for the clear breakdown on PE ratios! :) Buffett still has it, nice play on Goldman a few years back when all hell was breaking loose. Good point about going against the crowd. Do you use the volatility index (VIX) with your trades? Could be an interesting post.

  8. Good overview of P/E ratios. I recall doing such calculations and analysis when I was getting an MBA, and learned how important this ratio is. Personally, I have evolved into more of an index fund investor of late, so I don’t really focus on this metric. Though it’s probably good to do so, as I think about it, in terms of the overall market basket.

  9. I also think its really important to note the Trailing P/E is usually a better gauge than Forward P/E. Forward is only based on what the company’s guidance is…which can be very wrong. I like to stick to facts.

  10. I rely more on the PEG ratio than the P/E actually, but I do use both. If only I had more money so I could research stocks more often!!!

  11. Wow, absolutely great. This basic information is missing from so many investors. In my opinion, they should all know about P/E Ratios prior to investing in stocks. As you have shown, there are many important and relating derivatives from this ratio.

    • Thanks Romeo! Yes, it is a simple concept and historically it has worked in minimizing risk. Even though there are other metrics and one should consider them, an understanding of PE ratio is fundamental to investing.

  12. Nice breakdown of P/E ratios. I keep feeling like I should base my stock-buying on something other than “pretty charts”, but that’s the only thing that seems to make sense to me.

  13. Great write-up. That was very helpful.

  14. Glad to see someone quoting Ben and Warren. They have already shown us how it is done. It is up to us to follow their ways. P/E ratio is vital for understanding if a stock is reasonably priced.

  15. I thinks its a mistake to over-emphasise any one ratio.

    In addition, the PE ratio has a lot of variants and you need to pick which one is appropriate: value investors would probably use historical or CAPE, growth investors might look many years forward.

  16. What a fabulous post – thank you soooo much for explaining P/E in a way even I could understand.

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