How To Use P/E To Compare Stock Values

In a previous blog (here) I took you on a quick tour of the Yahoo! Finance and explained what some of the numbers and ratios mean. Today I will expand on one of the most prevalent ratios when analyzing stocks, P/E or the Price to Earnings ratio, also known as "the Multiple". Calculating this ratio is simple. You just take the stock price (P) and divide it by the earnings per share (E or EPS). The hard part is interpreting the P/E. There are no hard and fast rules that indicate what is a good or bad P/E.

You will find that this is a continuing theme in stock analysis. I would love to provide you with a check list of what makes a great stock but we live in a complex world where context is very important.

Using P/E to compare stock values

P/E serves a couple important functions. First, it provides a means of comparing the value of companies of different sizes. A common misconception when people look at stock prices is that a higher priced stock is more expensive than a lower priced stock. The truth is that there are a lot of factors that change a stocks price but to keep it simple consider these two;

• How much is the company worth? 
• How many shares of stock are in circulation?

Theoretically, if both of these numbers were concrete and indisputable you would just take the first number and divide it by the second (company worth / total shares) and that would give you a concrete stock price. Unfortunately, the first bullet is not a concrete number though. Many people will have many different opinions on a company's worth or total value. 

Since the company's total value is not concrete, financial analysts look to a company's earnings instead. Earnings are concrete, indisputable and reported quarterly by every publicly traded company. But stock analysis is about comparing company's to one another. How do you do that for companies of different sizes? McDonald's (MCD) is the largest fast food chain in the world. How can we compare its stock to say, Chipotle Mexican Grill (CMG). We just add up the previous four quarters worth of earnings (1 year) and divide that by the total number of shares in circulation. That gives you the Earnings Per Share (EPS).

EPS shows you the earning power each share represents, essentially telling you how much your portion of the company earns for each share you own. It is easy to assume that higher numbers are better but that isn't the whole story. What you and I am concerned about as investors is the value of a stock and to find that you have to consider what it cost, its price. That is where the P/E ratio comes in.

For example;

Apple (AAPL) has a stock price of about $393.30 and a EPS of just $25.56.

Coinstar Inc. (CSTR), owner of Redbox movie kiosks, has a stock price of about $54.23 and a EPS of $1.62.

At a glance most people would say that Apple is more expensive than Coinstar but Apple also has a much higher EPS and that has to count for something, right? How can you definitively compare them? You take the stock price and divide it by the EPS. It shakes out like this;

Apple: $393.30 / $25.56 = 15.56
Coinstar Inc: $54.23 / $1.62 = 33.54

What do these numbers mean? Well, at the current price you have to pay over 33 times what Coinstar has earned per share to by the stock where as you only have to pay just over 15 times EPS to purchase Apple. This seems to indicate that Apple is curently a better value despite the fact that the stock costs almost $400 per share.   

Analysis does not end there, of course. A lower P/E does not necesarily mean that the company is a better value or that it will provide better returns. But now you should have a better understanding of how and why those ratios were derived. I will follow up with another post that discusses P/E as an indication of potential earnings growth pretty soon. As always, f you have any questions feel free to post them to my comments section below and I will respond quickly. Thanks for stopping by.

3 Long Term Trends

When you are picking stocks for your retirement portfolio you don't want to have to fuss over them on a daily, weekly or even monthly basis. You should shoot for low maintenance stocks that you can buy hold and largely forget about. You can do this by purchasing industry leaders that support long term trends. These are trends, not fads. Fads can make you money but you have to babysit them. Below I have identified a few trends that I think are lasting. I also threw in a few companies that I personally think will benefit greatly from these trends.

NOTE: The companies mentioned below are meant as an example of how to play the trends I have identified. I am not recommending anyone purchase these stocks at their current prices without additional research and due diligence. 


E-Commerce -There isn't much that is out of reach if you have an Internet connection and a credit card these days. People are more comfortable shopping from home or on their mobile devices than they have been in the past and that seems to be a continuing trend. Obviously online retailers like online mega-store, Amazon.com (AMZN) benefit but retail is only one of the benefactors. I think some of the less obvious plays on this trend are potentially more lucrative in the long run.

Visa (V) is one of my top picks for playing this trend. E-commerce requires a credit card and Visa is the most widely used card out there and they get a cut of every transaction. I also think that the younger generation uses far less paper money than previous generations and I do not expect that to change. Not long ago it would seem silly to use a credit (or debit) card to buy a gallon of milk but that is normal these days. One must also consider the emerging markets. Many countries are improving the overall quality of life for their people and that includes infrastructure upgrades that lead to Internet access and access to credit. While I don't believe paper money will be phased out anytime soon, I do think the volume of credit card transactions is climbing steadily higher and will continue to do so for a very long time.    


Waste Disposal - This is a service that will always be needed and there is significant room for growth in emerging markets. Countries like China and India have vast populations that are clawing their way out of poverty into a rapidly growing middle class. Suddenly these people have income and access to all sorts of packaged goods that were previous unavailable or out of reach. This is going to increase the volume of trash and keep companies like Waste Management (WM) and Republic Services Inc (RSG) very busy for decades to come.

In particular, I like Waste Management. They are the largest waste disposal company in America and already have a number of joint ventures with Chinese companies that have given them a foothold in the world's fastest growing economy. It also happens that China has a vast and increasing problems with illegal dump sites, water contamination and mismanaged landfills. That foothold represents a lot of potential profit in the not too distant future. Waste Management is also a leader in the technologies that turn waste into fuel and sports an attractive 3.5% dividend yield.      


Green Technology - I am not buying into green technology companies right now because they currently rely too heavily on government subsidies and tax incentives to maintain their profitability. Those government subsidies and tax incentives are in danger during these uncertain economic times. However, I do believe that resource conservation is a long term trend and not a fad. Because of that belief I am on the lookout for a green technology company that has a sustainable business model.

Other ways to get in on green technology is by supporting (owning) larger, well established companies with significant green initiatives. For instance, automakers like Ford (F) that are striving to not only make their vehicles more fuel efficient but are making their manufacturing processes more efficient as well. Or a company like Johnson Controls Incorporated (JCI) that specializes in batteries and making  buildings more efficient (among other business lines) through the use of smart power control systems.

Teaching Our Children Financial Responsibilty

I am going to step away from my discussions on the Stock Market for a moment and answer a question that I get asked often by parents with young children. The question is "How do I teach my children financial responsibility?"

This is a GREAT question!
 
It is my firm belief (and the reason for this blog) that as a nation we are severely under-educated when it comes to finance. Ironic, considering we are the richest nation in the world and the founders of capitalism. Often financial lessons are learned the hard way and generally at the expense of our credit scores. The majority of our important life lessons are learned while we are still young children. whether we are talking about manners, good hygiene, sharing or financial responsibility.

My recommendation for teaching financial responsibility is simple really, an allowance but with a few significant tweaks. A typical allowance grants the child a set amount of cash on a weekly basis. This could be automatic or based on the child completing their chores. In my opinion, both of these methods are flawed.

How to teach the value of a dollar?

An automatic allowance teaches the child that they can get something for nothing and that just doesn't happen in the real world. I recommend a real allowance, not an entitlement. Tying the allowance to the child's chores is a step in the right direction. My concern is paying for chores that the kid should be doing anyway like keeping their room clean or doing the dishes after dinner. Those are obligations that are inherent to being part of the family. In an effort to teach the value of a dollar, I think an unintended consequence is a diminished acceptance of family responsibility.


So, how do you teach your child the value of a dollar without them trying to squeeze you for a few bucks every time they put a dish in the dishwasher or make their bed?

I recommend having two lists of chores. The first is a list of their responsibilities; things like keeping their room clean, helping with the common areas (vacuuming the living room, dusting the den etc), mowing the lawn and similar chores. This is stuff they do because they are part of the family and they  live in the house too. I believe rewarding these things monetarily under-minds the sense of responsibility to family that we all want our children to feel. Somethings you do because it is right without the expectation of a cash reward.

For the second list I recommend focusing on chores that the kids can do that make life easier for the parents or save the family money; things like washing Dad's car, cleaning the garage, doing the laundry (at least, their own), weeding Mom's garden, perhaps mowing Grandma's lawn. For this list you can set prices and add new tasks to the list as you go. Some of these jobs might be one time things like helping Dad tar the driveway. If you want to make the lesson especially realistic, you can focus on jobs that are unpleasant and time-consuming.

This teaches the value of hard work and of the all-mighty dollar but it doesn't necessarily instill the best spending or saving habits.

How to teach your child to save?

For this I recommend opening the First Bank of Mom and Dad. Make a deal with your kids that at the end of each month you will give them a nickel for every dollar they save. You can choose whatever interest rate you like of course but I think 5% is enough to make them think twice about spending without breaking your own piggy bank. In a previous blog (here) I wrote about the power of compound interest. Arming them with this knowledge early on can have a huge impact on their financial health for years to come.

How to teach financial discipline?

Financial discipline is all about delayed gratification and spending within your means. This is perhaps the most important lesson of them all because as soon as your children turn 18 they will be assaulted with dozens of applications for credit cards. While credit cards are not evil, they can cause a lot of damage if not handled correctly.

So, you have already provided an incentive for saving money but what do you do if they want advance on their allowance. Well, the First Bank of Mom and Dad can handle that too. If they need a loan, offer them the same terms (5% a month) with an additional fee if they are late with a payment, maybe an additional 10%. This may seem harsh but it is far more lenient than the credit card company will be.

Free Investing Tools for Beginners: Yahoo! Finance

In previous blogs I wrote about what the stock market is (here), how to find stocks you may be interested in buying based on your own knowledge and experience as a consumer (here) and a few tips for picking stocks for beginners (here). If you happened to have read them over the past few weeks (or hastily over the last 15 minutes) you may have some ideas for companies you want to invest in. But how do you find out whether your ideas are good ones? There really is only one way. Research. Don't worry, it's not nearly as dull as it sounds. 

So you have a company name. Where do you go from there?

Its time to do a little digging. You should be familiar with the product or service the company provides to some degree already but you have to find out more about the business. What is the company's ticker symbol? How big is it? Where do they operate? What other products and services to they provide and to whom? Who are there major competitors?

Eventually, these and other important questions will have to be answered, preferably before you decide whether to buy in or not. I write "eventually" because I think a layered approach is the most accessible. Over the next few blogs I intend to show you around some useful (and free) tool available right here on your friend the Internet. These are websites that I use to track the market and investigate companies that I invest in.

The first tool I would like to introduce is the Yahoo! Finance page. I think a visual aid will help so right click here and select "open link in a new window". Got it open? It might be helpful to have this page and the Yahoo! Finance page open side by side.

Welcome to the Yahoo! Finance homepage. Here you can check out some financial headlines, get a snap shot of the markets activities for the day (notice the chart a quarter way down the left side of the page) or use the "Get Quotes" search box (top left). I am going to let you poke around on the homepage on your own. I am more interested in the company pages on Yahoo! Finance. You access these pages through the "Get Quotes" search box.

Get Quotes: This search box is a great way to find the company's ticker symbol. The ticker symbol is a  unique identifier (usually 3 letters or less) used when trading stock. You likely have seen ticker symbols marching across the bottom of your television screen if you have ever flipped to CNBC or FOX Business channel. To find the ticker symbol just start typing the company name in the search box. A drop down list of companies will appear and you can select the intended company.

Go ahead, try it! If you don't have a company in mind take a look at Walt Disney Corporation (DIS). I split this page into 4 sections. I am only going to go over the first section today, the Stock Information. The otther sections, the Chart, the Headlines and the Links along the left side of the page, require a blog or more of their own.

Section One: Stock Information 
This is the section smack dab in the middle of your screen just below the company name. Some of this information is pretty intuitive but I am going to go over it line by line starting with the left-most column.

Last Trade: This is the price that this particular stock was sold for in the last trade. This isn't necessarily the price it is still selling for though. Price changes happen rapidly and there is a fifteen minute delay before this information shows up on your screen.

Trade Time: Another easy one. This is the time (or date if it is a weekend or holiday) that the last trade was executed.

Change: This line shows the difference in the stock price since the market open (9:30 AM EST M-F, excluding holidays). The arrow indicates whether the price has increased or decreased (also illustrated by the color: green for an increase, red of a decrease). It shows the dollar value of the increase and the percentage (in parenthesis).

Prev. Close: Short for previous close. This is the price that the stock closed at on the previous trading day.

Open: This is the price that the stock was at the market open. This price is often different than the previous day's closing price because there is after market trading in the US and other the markets around the world (Asian, European etc) effect US stocks as well.

Bid: Here you see two numbers that look something like this: 40.00 x 300 (or something similar). This means that there is a large open order to purchase 300 shares of this stock at the price indicated ($40.00 per share). This is the highest bid of the currently open orders. These numbers will change when this order is filled, canceled or modified so it is no longer the highest bid, or a new higher buy order is placed.

Ask: This is the flip side of "Bid". Here you see two numbers in the same format as above. The difference here is that instead of a buy order. This represents a large sell order.

SIDE NOTE: Often these numbers will change very rapidly for popular stocks and the two prices, Bid and Ask, will be very close, within pennies of one another. This is not always the case though. Some stocks will show a large gap between the Bid and Ask prices. This might indicate a divergence in public opinion. 

1y Target Est: Short for 1 year Target Estimates. This is supposed to be a prediction of what the stock price will be a year from now. Honestly, I am not sure where Yahoo! gets these numbers. I suspect this is the average, median or mean of a group of Analysts following the stock. Frankly, I put absolutely no faith in these numbers and I implore you to ignore them as well.

Day's Range: This is another easy one. This is the lowest and highest price the stock has traded for over the course of the day.

52wk Range: Short for 52 week Range. This one is similar to the Day's Range but instead of the day it represents the lowest and highest prices over the past year.

Volume: This is how many share of this stock have changed hands today. This number is often in the tens of millions for well known corporations. By itself this number doesn't tell you much.

Avg Vol (3m): Short for Average Volume (3 months). This is the average number of share traded daily over the past three months. If you compare this number to the number above it (Volume) you have an indication of how much interest there is in this particular stock. A spike in volume generally coincides with some news or event that may impact the stocks value. It is a sign that you should be looking for that news because it may require some action (buying more, selling etc).

Market Cap: This number is the perceived value of the company based on the price of the stock and multiplied by the number of shares outstanding. So, if you happen to be wondering how many shares of Disney stock are out there simply divide the Market Cap by the stock price for a ball park (accuracy is effected by how much rounding Yahoo! does to the Market Cap).

P/E (ttm): Here is where things start to get interesting. P/E is short for Price to Earning ratio, also known as "the multiple". To get this number you take the stock price (P) and divide it by the earnings per share (E or EPS). This is a very important number. A high P/E generally indicates a stock may be expensive or that there is a great expectation for growth in future earnings. A low P/E generally means a stock may be cheap or that the expectation for earnings growth is limited. It isn't as simple as that of course. I will write more about this in a later blog.

EPS (ttm): Short for Earnings per share. This number represent the company's annual earnings (think revenue or sales, not net income. I will write more about this when I go over financial statements) divided by the total number of shares.

SIDE NOTE: I am sure you didn't miss the fact that I ignored the (ttm) on the previous two definitions. It stands for trailing twelve months. This indicates that the EPS number is a total of the previous years earnings. This effects how we consider this information. A lot can happen in twelve months that can impact (positively or negatively) a company's ability to earn. Like everything, these numbers cannot be taken at face value. 

Div & Yield: This one is short for Dividend and Yield. I wrote briefly about dividends in a previous blog (here). The first number is the dollar amount you will earn annually for each share of this stock you own. It is often split into quarterly payments.

The yield is a percentage that represents the annual return you will gain simply for owning the stock. To find the yield you divide the dividend by the stock price. There are a lot of reasons that a high yield is attractive. First and foremost it is the closest thing to a guaranteed return you will find when dealing with stocks.