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Tuesday, April 10, 2012

More Fundamentals - P/E Ratio, EPS, PEG (OMG!)

When I started trading options I had to learn a whole new language. A lot of new words, meanings, and acronyms. It comes with study and time. Regarding Fundamentals, a few of these acronyms are EPS, P/E, and PEG.

These really belong with the section of my previous post about valuation and analyst's projections. After all, what we really want to know is what to expect from a stock. But I've separated them because I feel they deserve their own post given that they're widely used on Wall Street,are referred to on television, and in all books about investments. And for a long time, I had no idea what they were talking about!


EPS = Earnings per share. Earnings are another word for profit, so the amount of profit per share of stock is EPS.

P/E Ratio or "Multiple" as it's sometimes known = Price of the Stock divided by (12 months of trailing) earnings per share.

Before you can take advantage of the P/E Ratio in your own investing activities, you need to understand what it is. Simply put, the P/E Ratio is the price an investor is paying for $1 of a company's earnings or profit. In other words, if a company is reporting earnings per share of $3 and the stock is selling for $30 per share, the P/E Ratio is 10 ($30 per share divided by $3 earnings per share = 10 P/E).

I don't have to worry about the arithmetic. Most brokerages, and all the stock-quote systems on FinViz, Yahoo.Finance, etc. will automatically figure the price-to-earnings ratio for you.

Mind you, different sectors (the types of industries: technology, textiles, oil & gas, utilities, etc.) have different "normal" P/E Ratios, so you can compare equities within the same sector to get an idea of their standing. For example, technology companies may sell at an average P/E Ratio of 20, while textile manufacturers may only trade at an average P/e ratio of 8. There are exceptions, but for the most part, these variances between sectors are perfectly acceptable. What's important is how it's used. Get familiar with comparisons and these will start to make sense.

  So take these FinViz. com comparisons in the Technology Sector:

Apple's current price is $636. ($636 divided by EPS $35.11 = $18.12

Google's current price is $631

Yahoo's current price is $15.

So investors are willing to pay over $600 for $1 of Apple and Google earnings, but only $15 for $1 of Yahoo earnings. And yet look how close the P/E Ratios are. This tells you that Apple and Google are reasonably priced stocks, in spite of their high stock price.

Another way to look at P/E Ratio is that it could loosely represent how many years it will take to recoup your initial investment. I don't think this is widely used, however. Just for fun, let's take a look at some less and more flamboyant stocks:
Ford Motor Company (F) 's current price is $11.77
Chipotle Mexican Grill (CMG)'s current price is $416.60.

From what I've read, the higher the P/E Ratio, the more caution should be exercised. The high P/E's in dot-coms and real estate were tip offs that stocks were overvalued. This is not a sure-fire tool, but one of many in your Fundamental tool box. Just remember that because a stock is cheap doesn't mean you should buy it. Many investors prefer the PEG Ratio instead because it factors in the growth rate.

PEG RATIO = P/E Ratio divided by the growth % in earnings per share. In the examples above, the "EPS for next 5 years" is the percentage that is divided into the P/E Ratio. I understand that different websites use different growth rates to compute PEG, so you might want to acquaint yourself with which one you plan to use. On Chiptole above, you would take the P/E of 61.63 and divide it by the EPS next 5 yr of 22.02% to get a PEG of 2.80. If you compare the examples above, it is interesting to note that Apple has the lowest PEG of all, a very cheap stock indeed.

I admit to being a little fuzzy on these ratios, but it is helpful to me to know that a P/E Ratio of 200 is something I might question before I trade it. As I learn, I will revisit these subjects, but I am trying to record my learning, to date. If you google these ratios, you will find many, many articles explaining them much better than I can. But right now, with glazed eyes, I offer an introduction. ##

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