What is P/E Ratio? [and Why it SUCKS!] - YouTube

What is the PE ratio and how does it lose investors money?

Why is the most popular measure in stock investing almost completely useless?

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In this video, I’ll show you why the PE ratio is a sewer of information, how company

management tricks you.

I’ll also reveal three alternatives you can use to find the real value of stocks.

We’re talking price-to-earnings ratio today on Let’s Talk Money!

Hey Bowtie Nation, Joseph Hogue with the Let’s Talk Money channel.

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Investing is an entertainment industry.

Those of you in the nation have heard me say that before and today we’re talking about

the sitcom of the investing world, the slapstick comedy of stocks, the PE ratio.

Now I know you’re thinking, but everybody uses the PE ratio when talking about stocks.

From billion-dollar hedge fund managers and analysts on TV, even…yes we’ve even used

it here on Let’s Talk Money.

So how can it be the worst thing to happen to investors since Bernie Madoff told you

to invest in Enron?

Because the PE ratio is so phony that it’s almost worthless.

It’s an overly simplistic number that fools investors into thinking they know what a stock

is worth.

It’s an easy sound-bite for analysts to entertain you, keep you trading and losing

money!

In this video, I’ll show you what the PE ratio really means, why you should never trust

it alone.

Then I’m going to reveal three alternative ways to find a stock’s value that will help

you make better investments.

So let’s get right into it with the price-to-earnings ratio.

The appeal of this little investing gremlin is that it’s so easy.

It’s just the price divided by a company’s earnings or profits, usually counted over

the last year.

Every company with shares traded releases an earnings report every three months to release

their finances and performance over the quarter.

Since stocks are an ownership stake in a company’s profits, that earnings number is what everybody

fixates on and what gets the most attention.

So if we look at shares of Apple here on Yahoo Finance, and you can get those earnings numbers

from any investing platform or straight from the company’s financial statements, but

if we scroll down we see Apple’s total earnings per share of stock here.

Here we see that Apple reported $2.18 in profits for each share of stock last quarter.

It was $2.46 per share in the previous, $4.18 in the quarter before and $2.91 before that

for a total of $11.73 made by the company over the last year.

Scrolling back up, we see that shares are trading for $242.46 as I’m recording this

and if we take that price divided by the earnings, we get a PE ratio of 20.6 times.

What this says is that investors are right now willing to pay 20-times Apple’s annual

profits for a share of stock, an ownership share of future profits.

The media loves to talk PE ratios because it’s easy and investors eat it up.

It’s easy to calculate, easy to understand and gives you a comparison of value.

For example, if Apple trades for a PE of 20-times earnings and we see here that Microsoft trades

for 27-times, then we can say shares of Apple are relatively less expensive than Microsoft.

That little, tiny, innocent word ‘relatively’ is going to be important and we’ll get into

that but first, there’s actually two types of PE ratio and understanding the difference

is hugely important.

The one you see most often is called the trailing price-to-earnings.

This is the most common and just the price divided by that last year’s earnings.

Sometimes though, you’ll hear an analyst talk about the forward PE.

This is the price divided by the profits analysts think the company will make in the coming

year.

So obviously that’s a big difference.

One is the price against actual earnings.

The other is price against an estimate, and sometimes maybe not so great an estimate,

of what profits will be.

The problem here is that Wall Street expectations for a company’s earnings are almost always

higher versus the company’s past performance.

Even when some decrease is expected, it’s rarely more than a percent or two.

What this means is that the forward price-to-earnings, that current price divided by expected earnings,

is almost always going to be lower than the trailing PE ratio.

This makes stocks look cheaper because even if shares are trading for 20-times last year’s

earnings, an analyst can point to high hopes for the next year and say the price is only

like 15-times those expected earnings.

That’s warning #1 for the PE ratio, always be careful when analysts start talking about

the forward price-to-earnings ratio.

A lot of times it’s because the shares are ridiculously expensive when looking at that

trailing PE but look much more reasonable when you assume a year of higher profits.

The forward PE is like a 12-year old, the world is full of rainbows and unicorns and

stocks will always look better.

Now I want to talk about that word, relative, and why it’s so important before we look

at what’s wrong with the PE ratio and those three alternatives.

And even though I hate price-to-earnings, I want to spend time here talking about how

to use it right because I know so many investors are still going to be using it, even with

some of the alternatives we’ll look at.

So when you start looking at the PE ratio of a stock, the first thing you’re going

to wonder is, “Well, is this 20-times earnings for shares of Apple, is that good or bad?

Is it cheap or expensive?”

And this is where that seemingly insignificant word ‘relative’ becomes so very important.

A PE ratio for a stock is only good or bad, cheap or expensive, when you compare it against

another ratio.

Knowing that shares of Apple trade for 20-times earnings only means something if you know

that the shares have traded as low as 12-times over the last four years, or that 20-times

is about the highest it’s been over the period.

So here we can say that Apple shares trading at 20-times earnings are expensive compared

to their value over the last four years.

Another way of looking at the PE ratio of a stock is comparing different companies like

we did with Apple and Microsoft earlier.

But there are two things you need to know when you’re comparing PE ratios of two stocks.

First is that you absolutely must compare PE ratios of similar companies in the same

sector.

Comparing the price-to-earnings value of a fast-growing tech stock like Apple against

something in financials like Bank of America isn’t going to tell you anything about either

stock.

Earnings for tech stocks like Apple grow faster so investors are willing to pay more for those

earnings, a higher price-to-earnings multiple.

Even though it might be more expensive on a PE basis, shares of Apple might be a better

investment if that faster earnings growth keeps up.

In fact, here we see the current average PE ratio for the 11 stock sectors and the S&P

500 and you can see how much variation there is with energy stocks trading for a low of

17-times earnings and tech stocks trading for an average of almost 22-times earnings.

Instead, always remember when you’re comparing the PE ratio of two stocks or using any of

the alternative price multiples we’ll talk about, make sure you’re comparing stocks

within the same sector and industry.

Second here is that even comparing the price-to-earnings against two stocks in the same industry, it

might not tell you which is a good investment.

Let’s go back to that comparison between shares of Apple and Microsoft.

If Apple is trading for 20-times earnings and Microsoft is at 27-times, does that mean

Apple is a good investment at this point?

Does it mean you should avoid shares of Microsoft as too expensive?

What if shares of both companies are too expensive?

We’ve already seen that Apple has traded as low as 12-times earnings just in the last

four years.

That’s 40% less than where the stock is right now.

Always remember that the PE ratio is a relative measure.

It will only tell you if a stock is more or less expensive relative, or compared to, another

stock or a company’s own PE history.

To understand if the stock is a good investment, you have to take that lower PE ratio and combine

it with other analysis to understand the why behind the price and where it could be in

the future.

That’s the second warning about PE ratios, that you need to watch out when comparing

them.

Always compare the PE ratio of a stock against its own historical average and only against

the price-to-earnings of other companies in the same industry.

Now, why is the PE ratio so bad?

Why is something so simple and easy to use one of the worst ways to look at a stock?

Think of a company’s income statement, that’s where it reports those sales and expenses

and profits each quarter, think of it as a long trip down the sewer.

You jump in ankle deep where the company is reporting the sales it made over the three

months.

Now there are ways to fudge sales numbers but these are still pretty clean.

But then you start sludging along down the income statement.

The company reports the cost of its marketing and general expenses, each with more ways

to make the company look better…the sewage gets a little higher but you keep walking.

For example, remember when AOL shipped out all those annoying startup discs in the 90s?

OK, yeah, I’m old.

But when it did this, instead of saying, the costs here were a marketing expense which

would have decreased profits.

The company counted these as a long-term investment that it could write off over years.

It made earnings look way higher than they would have been.

Other accounting shenanigans include a company extending more credit to buyers so it books

sales even though the contracts may never be paid or just in the way it accounts for

inventory it’s holding.

With each expense the company reports, management has the opportunity to use a few more accounting

tricks to make expenses look lower and ultimately to make earnings look higher.

Pretty soon, you’re waist deep in a shitty income statement and looking at an earnings

number that has more fiction than a smut novel.

And why does Wall Street love the PE ratio even though everyone knows it’s bullshit?

Because when investors hear that shares of Apple are less expensive than Microsoft, what

do they do?

They rush out to sell Microsoft and buy Apple.

When the next day, they hear shares of Cisco are cheaper than Apple, they rush out to sell

Apple and buy Cisco.

It’s all an easy, entertaining way to get you to trade more and if you think trading

commissions were the only way brokers make money.

Think again.

Not only is investing an entertainment industry, it’s also a casino and the longer you keep

trading, the more money Wall Street makes.

So now let’s look at three alternatives to the PE ratio, three ways of finding a stock’s

value that are just as easy but will help you avoid the shenanigans that go into earnings.

First though, I want to invite you to a free webinar I’m giving on a unique goals-based

investing strategy I created working with private wealth clients.

In the webinar, I’ll show you how to personalize your investments to fit your own goals, to

make sure you’re making the right investing decisions based on your needs.

I’ll put a link to the webinar below the video in the description.

It’s completely free but the platform restricts how many can attend at once so make sure you

click through and reserve your spot.

Our first PE alternative is going to be the price-to-sales ratio which is probably the

second most used multiple.

The price-to-sales is simply the current share price divided by the sales per share reported

over the last year.

Now the difference between using sales and earnings to find a stock’s value might seem

insignificant but just think back to our sewer example.

The top line of that income statement, the reported sales number, is relatively clean.

As you walk down the statement through expenses and taxes and interest on debt, the accounting

shenanigans start piling up and the numbers get less believable.

So it just makes sense to use a number you know is cleaner.

The sales or revenue number isn’t reported on a per share basis as frequently as earnings

so there are two ways to find this.

First is you can take the market cap of the company, that’s the price times all the

shares issued, and divide that by the company’s revenue.

For example, we see that Apple has a market cap of one-trillion, 96-billion and revenue

over the last year of $259 billion.

That equals a price of 4.2-times its sales.

You can also find the price-to-sales calculated for you on a lot of sites but it’s really

easy to do the math yourself and I like to double-check the numbers.

The other way to find the price-to-sales ratio is divide total revenue by the number of shares

issued to get it per share.

So taking that $259 billion in Apple revenue divided by about 4.5 billion shares gives

us about $57.30 in revenue per share.

Then we take the price per share of $242 divide by revenue per share for that same price-to-sales

number.

Besides the price-to-sales ratio, another alternative to use is the price-to-book ratio.

The price-to-book ratio is the share price divided by the value of assets a company owns

minus the debts it owes.

You find the assets and debts of a company on the balance sheet, so it’s a totally

different financial statement apart from the income statement that shows earnings.

To find the price-to-book, look at the balance sheet and you can take the total assets minus

total liabilities or just take the line called total stockholders’ equity.

This is the investor ownership after debts are removed from the company’s assets.

Now that’s a whole company number, not per share so we need to do the same thing we did

with the revenue.

We can either take the market cap of the company divided by the whole stockholders’ equity

number, or we can divide the stockholders’ equity by number of shares and use the share

price.

Here we find that Apple has stockholders’ equity or book value of $107 billion so if

we take that market cap of $1.096 trillion divide by $107 billion, we get a price-to-book

value of 10.2-times.

And there are a few pros and cons of using the price-to-book value instead of the PE

ratio.

First is that the price-to-book ratio can be a better measure for companies with lots

of depreciation or other financial assets.

These can throw off the income statement so you want to use a price-to-book instead of

the PE ratio for financial companies like banks or real estate companies.

I like the price-to-book also because it gives you a valuation based on assets and what investors

actually own in the company, that stockholders’ equity.

The downside is that book value can also be manipulated by management so this isn’t

necessarily a sparkling clean number either.

The company’s assets include estimates for values of acquisitions that can be wildly

off from reality and liabilities might be skewed by interest rate assumptions.

Our third alternative to the PE ratio is price-to-cash flows and this is probably the cleanest of

the three.

The price-to-cash flows ratio is the stock price divided by the cash flow from operations

reported on the cash flow statement.

So here we’re using the third financial statement put out by a company each quarter,

the statement of cash flows.

This is where the company reports actual cash coming in and going out through operations,

investments and financing.

The major benefit here is that it’s much more difficult for management to fudge the

numbers on the cash flow statement compared to that income report.

This is actual cash flow in and out, so the accounting tricks available are harder to

come by.

Let’s say if the income statement is a sewer, the cash flow statement is more like a mud

run.

Still a little dirty but you won’t need a tetanus shot after reading it.

This is going to work like those other two, the price-to-sales and price-to-book.

You get the operating cash flows for the last four quarters from the cash flow statement.

You can either divide that market cap number against this, or get the per share cash flow

number by dividing it by shares issued.

Besides being a little more reliable, that price-to-cash flow ratio is also helpful when

a company is reporting positive cash flows but negative earnings.

Now remember, with all these price-multiples, these are all relative valuation measures.

The same rules apply here for comparing a price-to-book or price-to-sales of one company

against its own history or against similar companies in the sector or industry.

Click on the video to the right for the 10-step process I use to pick stocks.

This is a complete guide on finding the best stocks, the same process I used for venture

capital and private wealth managers.

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