One of the fundamental ways to value and compare stocks is with the PE, or Price-to-Earnings, Ratio. If you plan to do anything in the investing world—even if that’s just spectating or watching CNBC—you’re gonna feel lost if you don’t understand this ratio.
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Because a company’s share price does not in any way reflect its value, it’s not helpful at all in our effort to value and compare companies. Apple, despite its $150 share price, is still worth $150B more than Amazon, with its $1,500 share price.
The Price-to-Earnings Ratio provides us a simple way to assess the value we’re actually getting when we purchase a share. It measures how much you’re paying for every dollar of a earnings.
You can use the PE ratio to gauge how similar companies in similar industry sectors compare to each other.
The PE ratio is made up of two variables: a company stock’s Price Per Share, or PPS, and a company’s Earnings Per Share, or EPS.
Price Per Share is easy to see. It’s simply the share price at which a company’s stock is currently trading.
Earnings Per Share
EPS, on the other hand, requires a little calculation. It’s the company’s profit divided by the number of shares outstanding: the amount of profit that could be attributed to each of those individual shares you’re considering purchasing.
It's the kind of calculation you would do with any investment: I’m going to buy this house for $100,000, which is renting for $5,000 per year—that would be your Earnings Per House.
There's obviously a lot more that goes into your decision, but when you’re considering an investment, you want to know how much its producing. Earnings Per Share gives us a quick and easy (albeit incomplete) glimpse at this.
Thus, when you’re comparing the price of a share to the earnings per share—in other words, when you evaluate the PE Ratio—you learn how much investors are willing to pay for every dollar of earnings, or how much you would have to pay for each dollar of earnings.
At the time of this recording, Google (or Alphabet’s) shares are trading around $1,000 per share. Its Net Income over the last 12 months was just under $17B and there are about 700MM total shares outstanding. That means they earned around $24 per share ($17B/700MM shares). With that information, investors have been willing to pay the current $1,000 price per share; they’re willing to pay around $42 (Price/EPS or $1,000/$24) for every dollar of earnings. You could say Google has a PE Ratio of 42.
You can compare that to the fact that investors are only willing to pay around $16 for every dollar of earnings from Apple: Apple’s PE Ratio is 16.
Netflix’s is a little over 200. Amazon is over 250.
You might also want to use this number to compare a company to its industry or sector. The technology sector, for example, right now has an average PE Ratio of just under 43.
Or you could look at the market as a whole. For example, you could use the Standard & Poor’s 500 as a proxy for large United States companies. It’s PE Ratio right now is around 25.
How to use PE ratios in research
From these numbers, it would appear investors are expecting much more future bottomline growth from Amazon than Apple. If you have reason to disagree—if you believe Apple will grow just as much or more than its competitors—perhaps you have the start of an investment thesis that Apple is undervalued, and thus would make a good investment for your dollars.
Or, on the other side, maybe you think investors are overestimating Amazon’s future, and you have a case for its stock being overvalued.
Neither one of those reflects my personal opinion. They just serve as an example of how PE can offer a down-and-dirty, side-by-side industry comparison—and how it could help steer the direction of your research.
Where PE falls short
So, depending on how you compare it, a company could appear over-, under-, or appropriately valued based exclusively on its Price-to-Earnings Ratio. But obviously, there is much more to a company than its earnings over the last 12 months.
For example, as I just mentioned, this calculation in no way accounts for expected future growth, which is likely the reason Amazon consistently maintains a high ratio. On top of that, it also doesn’t accurately account for a company’s current financial position (considering important factors like debt and cash reserves). Many investors prefer to use a metric known as Enterprise Value to account for that as well. Additionally, consider the fact that net income does not accurately account for a company’s current operating performance, like the metrics EBIT or EBITDA might.
If you missed either of the videos I did explaining those subjects, be sure to check them out.
Despite its shortcomings, you’ll still hear PE Ratios referenced all the time in the investing world. Its quick-and-easy calculation offers a convenient metric for initial comparison and cause for further research and analysis. But you should stop there. Definitely do not use a company’s PE Ratio as the primary driver for your investment idea. Try to figure out what else is going on with the company. Is there a reason for any discrepancies you may have discovered?
I hope you find this information helpful on your path to building your rapidly-growing, highly-diversified net worth. I really do hope so, because that’s my goal. If so, stay tuned, because I have a whole lot more in the works for you!