Hi Friends
I remembered years ago when I encounter with the uncles and aunties who got themselves in the stock market though many of them are speculating, they will be looking at charts, talking about the past prices of stocks, their intuition and gut feel and so on. The only thing that is probably close to the fundamentals that they talk about is P/E Ratio.
I am going to explain such ratios assuming that you are a total newbie in investing.
(I) PE Ratio
PE Ratio is a abbreviation for Price-to-Earnings Ratio. Price is the current stock price (or market price) of the company per share. If you go to any stock chart, the price that is shown is the current stock price of the company per share.
Earnings, in this case is Earnings Per Share (EPS). Earnings, also known as Net Income simply means the amount of money that a company makes after paying off all expenses which includes tax. Earnings or Net income of a company is always presented quarterly when they have their quarterly earnings announcement and end of their financial year, an entire year’s earnings. As such, Earnings Per Share means dividing the Earnings of the company by the number of Outstanding Shares. Outstanding Shares are shares owned by investors, company staffs and members of the public. In simple terms, when you logged into your brokerage account and the number of shares that you are able to purchase through the platform, these shares are outstanding shares. Shares that are repurchased by the company are not outstanding shares.
In terms of Formula, it looks like this:
Eg. If the company is selling in the stock market for $10/share and it is making $2/share, their PE Ratio will be $10/$2 = 5.
So what does it mean when a PE Ratio and higher than another? Eg. If a PE Ratio of Company A is 20 while PE Ratio of Company is B, it simply means that the market is willing to pay $20 for $1 of earnings for company A and the market is willing to pay $5 for $1 of earnings for company B. Assuming company company A & B are doing exactly the same thing, which is cheaper? Company B of course. But do bear in mind that PE Ratio is NOT a method to valuate a company and Benjamin Graham has said in his book, Security Analysis, that “This does not mean that all common stocks with the same average earnings should have the same value.”
Benjamin Graham (also known as the father of Value Investing) has calculated average ratios for the periods 1871-1970. The lowest average in that period was 9.5 (1941-50) and the highest was 18.1 (1961-63). He consider any PE ratio of less than 16 over the past 3 years as considerable and anything above 16 to be speculative.
On the other hand, Warren Buffett, has commented that investment ratios such as PE ratio are no guide to value. In an excerpt from his 2000 letter to shareholders he wrote the following:
“Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”
SO BE CAREFUL WHEN YOU LOOK AT PE RATIO ALONE!
(II) PEG Ratio
This ratio is popularized by Peter Lynch in his 1989 book One Up on Wall Street that “The P/E ratio of any company that’s fairly priced will equal its growth rate”, i.e., a fairly valued company will have its PEG equal to 1. What does it mean? Hang on there.
PEG Ratio originally developed by Mario Farina who wrote about it in his 1969 Book, A Beginner’s Guide To Successful Investing In The Stock Market.
In terms of Formula, it looks like this:
You already know PE ratio or Price/Earnings. What is ‘Annual EPS Growth’? Let me ask you something. If you are to invest in a company, do you want the company’s Earnings to continue to grow, stay stagnant or decreasing? Obvious, isn’t it. You will want the company to make more and more money each year. So how much do you think a company’s earnings would grow? At what rate per year? That’s ‘Annual EPS Growth’ in the formula above.
Eg. If a company has a PE Ratio of 20 and it’s Annual Growth rate is 20, then it’s PEG = 1 (ie. 20 divided by 20).
So if company A has PEG of 1.5 and another company B has PEG of 0.5, what does it mean? To put it simply, for company A, the market is willing to pay 1.5 times per unit growth whereas for company B, the market is willing to pay o.5 times per unit growth. So which company is cheaper? It’s company B assuming all equal for the rest.
In terms of application, PEG < 1 is considered is desirable (and may provide higher returns) as compared to PEG > 1 BUT do note that in all formulas, the output depends on the input and this ratio again used as a Rule of Thumb.
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Cheers!
Cayden Chang
Mind Kinesis Value Investing Academy