Decoding stock talk.
One of my goals on The Money Minute is to turn you into the financial expert and empower you to make the financial decisions that work best for you. The best financial advisor for you will always be in the mirror. While I’m a close second, no one— absolutely no one— will care more about your money than you!
One of the biggest barriers to entry for people like me who didn’t grow up with the Wall Street Journal on their kitchen table is the jargon. And boy oh boy is there a lot of jargon in the finance land. Especially when it comes to investing.
If you’ve ever watched financial news, you’ve probably seen updates on stock prices scrolling at the bottom of the screen. Sometimes those numbers go along with abbreviations like “EPS,” or “Vol.” I do think it’s important to be able to decipher these abbreviations, because it will help you shut down any brokers who try to take advantage of you. Knowing when a stock looks bad on paper can show your broker that you know what you’re talking about.
Let’s start with one of the most common metrics: P/E ratio. I will say, P/E ratio is the metric that can be the biggest mind f*ck, but don’t let it get you. You did harder things in PE class than calculating P/E ratios. As we get into the nitty gritty, keep this intel as your North Star: P/E ratios are used to help investors gauge how much bang they’re getting for their buck, or whether a company is really worth how much people are paying for it.
Double clicking on P/E.
The big picture is that a P/E ratio of a stock represents the relationship between a stock price and the earnings per share. Let’s not worry about earnings per share right now, but what you need to know is that it’s a measure of the company’s profitability, specifically with respect to investors.
Most data on stocks will give you the P/E ratio, but you can calculate it yourself. You do that by dividing the stock price by earnings per share. And again— we don’t have to talk about earnings per share just yet, just remember it’s a metric investors look at to see how profitable an investment might be.
Let’s take an example.
Let’s say you were looking at investing in a company called the The Money Minute Company. And you know that the stock price is $20 and the earnings per share is $10. To find the P/E ratio, you would divide $20 (the stock price) by $10 (the earnings per share) and get a P/E ratio of 2.
$20 / $10 = 2
The way to think about this equation is that the stock price (the numerator) is the investor’s lane. Right? That’s their offering, what they put in, their end of the bargain. The earnings per share (the denominator) is the company’s lane. It’s the measure of the company’s value to the investor. Even if our fraction days are long behind us, we probably somewhat remember that if the numerator is bigger than the denominator, your ratio is going to spit out a bigger number; while if you have a relatively bigger number on the denominator, you’re going to get a lower number.
And don’t worry if you just lost me— I’m not going to drill you with ghosts of math class’ past, but remember here that the numerator of this fraction represents your (the investor’s) contribution. So when the P/E ratio equation spits out a bigger number, that means that your contribution is relatively higher than the company’s. Are you with me? If so, it will make sense to you that typically, conservative investors say: the lower the P/E ratio, the better. The lower the P/E ratio, the more value you’re getting from a company, and, of course, as investors, we’re going to want to get the most value out of what we’re spending our money on.
If the P/E ratio is high, that means you’re paying a high price for a company that has low earnings per share. If that doesn’t feel ideal, you’re right. You’ll typically see that conservative investors feel that a P/E ratio of 15 is good value. Let’s gauge this with some of our value stocks. At the time I’m writing this, Verizon’s P/E Ratio is 8, JP Morgan Chase’s is 9, Goldman Sachs is 7.
But, let me pop this nice, neat illusion: at the time I’m writing this, the Walt Disney Companies, one of the largest companies in the world has a P/E ratio of 73.
Are you thinking “Lapin! You told us a P/E ratio of 15 is considered a good value. Walt Disney is one of the biggest companies in the world! Are you telling me that it’s not valuable?!”
No, I’m not, because here’s the catch: a high P/E ratio means that the investor is contributing relatively high compared to how much profit a company is making. But here’s the thing: low profit—even zero profit (and therefore, zero earnings per share), isn’t always a bad thing. Does that go against everything you’ve ever known about business? Before your mouth freezes in that open-mouthed stare, let me explain.
There are two reasons a company might not be profitable: first, they suck and they’re not making any money. That’s what we may have assumed, and are now seriously stumped because we know that the Walt Disney Company certainly does not suck.
The second reason a company might not be profitable is because they’re taking all of the money that they’re making (their revenue), and putting it back into the company. I’ve alluded to this a few times, and we’ll get more into this in future articles, but a company that is pouring money back into its operations, can be a sign of a growing company. For example, maybe all of the company’s revenue is going straight into a brand-new technology that everyone is going to want to buy. I’d invest in that stock, wouldn’t you?
My two cents?
It is super valuable to understand the technical analysis of stocks, but you can’t get the whole story on an investment based on one metric. As we saw in this article, good investments can have high or low P/E ratios. Therefore, in order to decide whether you should invest in a particular company, you’ll have to look into additional factors that we’ll get into in future articles.
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