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.
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!
Here’s Apple’s PE ratio from three different sites:
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
During 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!