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RIIQ Newsletter

Good morning investors!

If this is your first time reading, welcome to Raising InvestorIQ!

Every Sunday morning, we publish a free write-up within our RIIQ Newsletter with leading insight and analysis — the aim is to help investors of all skill levels focus on key fundamentals, gain confidence in developing an investment strategy, and gain an edge in the push to generate true wealth.

Grab your coffee and let’s dive in!

The Price-to-Earnings Ratio - Broken Down For You!

Why the P/E ratio is your financial compass

Deep-Dive

When it comes to figuring out if a stock is worth your hard-earned cash, the Price-to-Earnings (P/E) ratio is your go-to tool. It’s commonly used as a quick valuation technique, and you’ll notice that P/E ratios are readily available on company profiles of most all investing tools, such as Seeking Alpha.

The P/E ratio compares a company's current share price to its earnings per share (EPS), giving you a snapshot of what investors are willing to pay for each dollar of earnings. Think of it as a quick gauge for whether a stock is a bargain, overpriced, or just right based on its earnings.

In a nutshell, the P/E ratio is your financial compass, helping you navigate the stock market with confidence and clarity. But it’s not the only one, stay tuned for other key indicators in the coming weeks!

So, with a bit of knowledge and a methodical approach, anyone can equip themselves with the tools needed to evaluate a company's performance and make more informed investment decisions. Financial analysis doesn’t have to be reserved for the experts; it can be accessible to anyone willing to learn and apply some basic principles.

At Raising Investor IQ, our mission is to demystify these financial concepts and make them more approachable, and we’re here to guide you through these essential metrics, so let’s dive in!

A Deep Dive Into P/E Ratio

This is the favorite tool for investors looking to quickly gauge a stock’s worth. This ratio matches up a company's stock price with its earnings per share. Think of it as a way to see how much you’re paying for every dollar the company makes. It's a go-to metric for those who wants to figure out if a stock is a hidden gem or maybe a bit overhyped.

So, what makes the P/E ratio so useful? Well, it’s all about context.

A high P/E might mean the market expects big things from a company, hinting at future growth. On the flip side, a low P/E could suggest the stock is undervalued or the company’s facing some challenges.

But don't just look at the number in isolation – comparing it to industry benchmarks or similar companies gives you a better sense of where things stand.

You should also look at current P/E ratios for prospective companies versus the historical P/E ratios for those same companies. Is it higher or lower than historical averages? The decision to invest is not simply a question of whether the P/E is high or low.

Take the tech world, for example. Tech companies usually sport higher P/Es because of their growth potential. Compare that to utilities, which often have lower P/Es due to their steady, predictable earnings.

And here’s where it gets even more interesting. The P/E ratio isn’t just a number; it’s a gateway to different investment strategies. Value investors might hunt for stocks with low P/Es, betting that the market will eventually recognize their true value. Growth investors, meanwhile, might chase after higher P/E stocks, banking on the company’s earnings to keep climbing.

The Formula

To determine the P/E ratio, use the following formula:

It’s as simple as that.

For example, if a company's share price is $50 and its earnings per share are $5, the P/E ratio is calculated as follows:

This figure indicates that investors are willing to pay $10 for every dollar of earnings generated by the company, and this provides a starting point for assessing share valuation. We'll give a real-world example later in this section, so stay tuned!

Let's take a closer look at things with a concrete example. We’ll begin by breaking down the different ratios. Read more below..

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First up, we've got the Trailing P/E Ratio. This one looks at the actual earnings over the past 12 months. It's like looking in the rearview mirror—reliable because it’s based on verified historical data. Investors love it for its dependability, but keep in mind, it might not show the latest changes in the company's performance or the market dynamics. If a company has had significant recent ups or downs, the Trailing P/E might miss that.

Then there's the Forward P/E Ratio, which is all about the future. This one uses projected earnings to give you a sneak peek into how the stock’s valuation might shape up. It's super handy for estimating the impact of future earnings. However, these forecasts can sometimes be overly optimistic or just plain wrong, adding a layer of uncertainty.

More generally, by stacking up the P/E ratios of different companies, you can spot the ones that seem undervalued or overvalued compared to their competitors. This sector-specific comparison is like getting the inside scoop on how a stock stacks up against others in the same game.

Also for the long haul, it’s smart to look at a company’s historical P/E ratio. Tools like the P/E 10 or P/E 30, which average earnings over the last 10 or 30 years, can give you a solid idea of long-term trends. This lets you compare the current P/E ratio to the company’s historical performance and see how it matches up with past economic cycles. This kind of historical analysis helps you understand the ebb and flow of P/E ratios and spot trends that might influence future valuations.

To better understand this concept, let's look at a concrete example.

Walmart & Costco: why do P/E differ?

To illustrate this ratio, let's take the example of Walmart (WMT) and Costco (COST), two American retail giants operating in a similar sector, with share prices of $68 and $801 respectively at the end of July 2024, and earnings per share of $2.33 and $16.14 respectively. This gives us P/E ratios of 29.2 for Walmart and 49.7 for Costco.

Costco’s higher P/E ratio compared to Walmart’s indicates that investors value Costco more. Here’s why:

• Growth Expectations: Investors expect faster growth from Costco due to its expansion and innovations. Walmart, being more established, grows more slowly.

• Business Model: Costco’s membership model offers higher profits and customer loyalty, attracting investors. Walmart’s traditional model is stable but has lower returns.

• Risk Perception: Investors might see Costco as less risky due to its strong management, accepting a higher P/E ratio. Walmart’s perceived risks may lead to a lower P/E ratio.

• Market Comparison: A higher P/E ratio for Costco reflects its better earnings potential or competitive position compared to Walmart.

In short, Costco’s high P/E could mean it's overvalued with less growth potential, while Walmart’s lower P/E might indicate a safer, steady investment.

A Double-Edged Ratio

As we've said, a low P/E ratio can indicate that a stock is undervalued, meaning that it may be a good buying opportunity if the market hasn't yet recognized its true worth. However, a low P/E ratio can also indicate that a company is experiencing difficulties or that its growth prospects are weak.

Conversely, a high P/E ratio may indicate that the market has high expectations of a company's future growth and earnings, which can be positive. But it can also suggest that the stock is overvalued, making it potentially risky if the company fails to meet these high expectations.

Let’s take an example, with McCormick (in orange), global leader in spices, versus J.M. Smucker (in blue), another food-company:

McCormick benefited from the pandemic and people stuck at home with little to do but cook. But the stock seems overvalued now that the pandemic is over and inflation is driving up costs. Despite its high margins due to its leadership status, overvaluation relative to its competitor (with a ratio twice as high!) may be risky if demand falls and costs rise drastically.

Also, keep in mind than despite its popularity, this ratio isn’t perfect. For instance, it can be misleading for companies without profits or those suffering significant losses. In such cases, the P/E ratio can turn negative or become undefined, making analysis tricky. Moreover, P/E ratios can vary greatly across different sectors due to varying growth rates and valuation practices. High-growth companies might show high P/E ratios due to their promising future earnings, while more mature companies might have lower ratios because of their steadier growth.

Alternatives to the P/E Ratio

To get a fuller picture beyond the P/E ratio, several other financial metrics can come into play, as for example:

• The Price-to-Book Ratio (P/B) compares a company’s market value to its book value. This is especially handy for companies with significant tangible assets, like financial institutions. It helps you see if the market values the company above or below its book value.

• The Price-to-Cash Flow Ratio (P/CF) looks at the cash flow generated by the company, giving a different take on profitability by focusing on available liquidity. This ratio is useful for evaluating companies where accounting profits might not reflect their true cash-generating ability.

• The Price/Earnings to Growth Ratio (PEG) adjusts the P/E ratio by taking the earnings growth rate into account. By factoring in future earnings growth, the PEG ratio provides a more balanced and complete view of a stock's valuation, considering both the current P/E level and future growth prospects.

• Earnings Yield - another solid alternative to the P/E ratio and a personal favorite of the RIIQ team, Earnings Yield [calculated as EBIT (Earnings Before Interest and Taxes) divided by EV (Enterprise Value)] gives a holistic view. It considers not just equity but also debt—a total snapshot of what's paid for the business. See, EV incorporates the equity price and the debt used for operations.

While the Price/Earnings ratio is a key indicator for evaluating stock valuations, it’s important to use it wisely. For a more precise and comprehensive analysis, you have to compare the P/E ratio with historical values and use it alongside other financial metrics.

A deep dive that includes sector comparisons and earnings forecasts can offer a more nuanced view of a company’s valuation and future prospects. By combining the P/E ratio with other financial indicators and considering sector specifics, investors can get a fuller picture of stock performance and valuation.

And don't worry about that, we'll be back regularly with more financial indicators in future Key Investment Insights!

Key Insight

A low P/E ratio can indicate that a stock is undervalued, meaning that it may be a good buying opportunity if the market hasn't yet recognized its true worth. However, a low P/E ratio can also indicate that a company is experiencing difficulties or that its growth prospects are weak.

Conversely, a high P/E ratio may indicate that the market has high expectations of a company's future growth and earnings, which can be positive. But it can also suggest that the stock is overvalued, making it potentially risky if the company fails to meet these high expectations.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.