Every stock market enthusiast who has turned on CNBC or Bloomberg TV has heard the phrase “Is that stock expensive?” As a Chartered Financial Analyst (CFA) and a former stock researcher, I get this question a lot from family, friends and acquaintances.
When it comes to products, one carrying a $10 price tag is more expensive than a $9 one. It is a simple concept. But you might hear experts passionately debate on whether a $600 stock may be less expensive than a $38 stock. When it comes to stock prices, cheap expensive is a relative concept, and a somewhat subjective one.
Relative to earnings. Relative to peers. Relative to the broad stock market. Relative to its own growth potential.
Earnings per share (EPS) refer to the net income divided by the total number of common shares. For example, if a company earns $100 million, and has 100 million outstanding shares, its EPS is $1.
P/E ratio is stock price, divided by EPS. Most often, the EPS used is an estimate for the current fiscal year (2012, called forward P/E), although it could be the EPS for the last four quarters (called actual or trailing P/E). For example, if the stock price is $20, P/E ratio is 20 times or 20x.
This P/E is what most experts refer to when they discuss if a stock is cheap or expensive.
The next question becomes, what is the market P/E? For this, experts use the same methodology, but use the S&P 500 index as a stock market proxy. S&P 500 earnings estimate is a consensus of all the earnings estimates from Wall Street research firms, calculated using either a top down or a bottom up approach. Say the market P/E is 15x.
At this point, an investor can see that our example stock, at 20x is more expensive than the market, which is at 15x.
But what if a company is growing earnings much faster than the market? Say the market is growing earnings by 7%. On the other hand, our company is expected to grow earnings by 35%, which is common in less mature, fast growth industries. Then, our estimated EPS would be $1.35, and the forward P/E would be 14.8x. Suddenly, our example company starts to look like a cheap stock. The expectation of faster earnings growth is why many stocks trade at higher P/E multiples (called a premium valuation) for an extended period. The P/E divided by the expected earnings growth over the next five years is called a PEG ratio.
Generally, companies that compete head to head should have similar growth prospects. Let’s say the example stock’s competitors in the same industry are trading at a 25-30x P/E multiple. Then the 20x multiple stock could appear to be cheaper than its peers, even though it is more expensive than the market. This is called comparative valuation, or comp analysis, and it is the most common way of judging whether a stock is cheap or expensive.
This is of course back of the envelope valuation. Buy and sell side analysts often fine tune earnings estimates to get a truer P/E ratio for the companies they “cover.” There are also many other ways of figuring out if a stock is cheap or expensive (for example, P/E will not work for a loss making company) like EV/EBITDA, Price to sales, Price to book etc. but the P/E remains the most often used measure to examine the relative value of a company stock.
The next time you are tempted to buy a stock, rather than believing the hype, take a few moments to calculate its P/E ratio. The data is readily available in Yahoo Finance, under the Investing tab. Put in the company’s stock ticker, and try to read into the Key Statistics to figure out if the stock is cheap or expensive. Then surprise your friends and family by saying that a $120,000 stock (Berkshire Hathaway) appears cheap! As always, remember that investing in the stock market has many risks, and any stock can at any time lose value. But trying to answer the most basic question “Is that stock cheap or expensive?” can be the first step to becoming a successful investor.
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