This is Andrew Horowitz with the Winning Investor’s Quick and Dirty Tips for Beating the Market. Today I’ll give you more tips for using P/E ratios to evaluate stocks. Remember in a previous episode I talked about the P/E ratio, which is helpful for comparing stocks and choosing the best ones. But before you can calculate the P/E ratio, you need to know the earnings per share number or EPS. You can find this number easily by looking at any popular financial website like Yahoo or Google Finance or MSN Money.
What is the Earnings Per Share Number?
The EPS number reflects net income (the total amount a company earns) without dividends, divided by the number of shares outstanding. Essentialy shares outstanding are all the shares that are out there that the company had issued when they did their offering to the public. Dividends are payments often given quarterly to shareholders as a way for companies to “share” their profits. They are in this instance removed for clarity when calculating the EPS number because, though many companies do offer dividends, some do not. Of course you generally want to see a high earnings per share number, but just like the P/E ratio, what's important is to compare companies in the same industry. Comparing companies in the same industry will allow you to look for stronger companies, because stronger companies will usually have higher earnings per share.
How to Use P/E Ratios to Compare Companies
Let’s look at two popular companies. Let’s look at Google and Apple.
Assume Google trades right now at somewhere about $400 per share and has an earnings per share value of $13.31. That means we can expect them to earn $13.31 for every share out there. Right now, Google has 315 million shares outstanding. So why doesn't Google's stock trade at $13 per share? Isn't that what it's worth from an income standpoint? The answer simply is "no" and here's why. Remember that many investors look to hold stocks for a long time, and they expect a company to keep making profit during that time, so they're willing to pay up a premium right now in hopes of getting higher prices later.
The P/E ratio helps determine how much investors are willing to pay. So if Google is at $400 with an EPS of $13.31, then the P/E ratio is the divider of the two, approximately 30. That means investors are willing to pay 30 times current earnings per share to own a piece of Google.
Now let's say at the same time that Apple trades at $130 per share with an earnings per share of $5.38. You simply divide the share price $130 (which, of course, changes every day) by $5.38 (which is more stable and comes out about quarterly to get that information) to find that Apple's P/E ratio would be about 24. Now you see that investors are willing to pay a higher premium to own a share of Google than of Apple, and that's not just because the stock price is almost three-times as high. If you keep looking at P/E ratios of other technology companies, you may find that most of them are nearer the 20 area like Apple, and that Google might be considered "expensive" relative to its technology peers. That's valuable information to know and you can't always tell why a company is truly expensive or a good bargain just by looking at its share price. We’ve talked about that. Most of the time, higher share prices will translate into higher P/E ratios, but that's not always the case either. So what you want to do is focus on the P/E, the PEG ratio that helps you compare Apples to Googles... I mean Apples!
Comparing More Stocks
Just for fun let's compare a few other stocks. Wal-Mart has a P/E ratio of 14.95. However, energy stocks and companies like Exxon-Mobil have a P/E ratio of about 7.5. Wow! That seems low compared to all the stocks we've been discussing so far. But is it really? You'll have to look at other energy stocks to compare them. Again we’ve looked at the industry and we compare them together. Let's look at an energy company with a very similar price. So let’s look at industry companies with a similar price. Let’s assume Chevron Corp (CVX) trades right now at about $66 while Exxon-Mobil trades at about $67. The P/E ratio for Chevron is 5.66 whereas the P/E ratio for Exxon-Mobil is 7.79. Though the price is almost the same, Exxon-Mobil's P/E ratio is almost 40% higher than Chevron's! Does that seem cheap now? You'll have to keep looking at other related energy companies to see if those P/E ratios are really cheap compared to other energy companies -- that's your homework for the week, kids! Go into the energy sector and look at all the P/E ratios and find the ones that are cheapest and then compare some of their past earnings history.
And remember, if there a question you’d really like to ask just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show. And if you like the show, tell a friend and leave a review on iTunes. This is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market. Talk to you soon.
