Unit 2 LESSON THREE: APPLYING THE P/E RATIO

Unit 2 LESSON THREE: APPLYING THE P/E RATIO

By Nicholas Murja

We now know that Mr. Market isn't rational. Stocks are bought and sold based off emotion and not facts. Our job as value investors is to find a $10 dollar bill that is on sale for $5. Today we learn about a ratio that can quickly tell us if a stock is on sale.

Ratios help investors quickly analyze stocks to evaluate performance, predict what will happen in the future, and assess the value of a stock. The P/E ratio measures how much investors are willing to pay for each dollar of earnings.

P/E Ratio

Let's look at a couple examples to see what this is all about!

What are we learning today?

Rookie Contracts - Per Game

Why were the Cavs willing to pay more for the same amount of points?

• Per Game Salary - $37,000

​Carmello Anthony

• Per Game Salary - $50,000

Lebron James

​$1,761 per point

​$2,380 per point

Open Ended

Both players had tremendous hype coming into the NBA. Why were the Cavs willing to pay Lebron $619 which is 35% more per point?

The Cavs believed that Lebron had more potential to increase his output

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...and he did.

19 years later the stats speak for themselves. Had the Cavs been able to keep Lebron they would have recieved much more than the Nuggets would have for Carmelo.

Why are investors willing to pay so much more for so way less revenue?

• 2020 Revenue - $31 Billion

• Stock Price - $661.77

Tesla (TSLA)

• 2020 Revenue - $127 billion

• ​Stock Price - $9.25

Ford (F)

​The same sort of thing happens with stocks too.

Open Ended

What "potential" do Tesla investors forsee that drives up the price?

Investers are predicting the future. Value investors make sure that the numbers back up their beliefs. Many other investors buy what is most popular regardless of facts. This drives up the price and creates a lot of risk.

Predicting the future...

Open Ended

What is the risk Tesla investors face when they purchase a stock based on hype and not numbers?

Remember the P/E Ratio?

The P/E measures how much investors are willing to pay for the earnings per share.

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Simply, the more investors are willing to pay for a dollar, the the price is based off hype and instead of reality.

Wouldn't it be nice to be able to easily determine how much of the stock price is hype?

RBLX

P/E Values can vary. Use Yahoo Finance to find the values for the three companies above.

​​INVE

​​INTC

RBLX

RBLX doesn't have a P/E because they don't have any earnings. This is common for new companies.

​​INVE

​​INTC

Identiv is a company that secures data and physical locations around the world. In Dec 2021 they posted huge growth, but still don't have positive income.

At one time, Intel was a the biggest name in technology. There has been talk that they would make a comeback but clearly the market disagrees

• EPS = Net Income / Shares

• P/E = Stock Price / EPS

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P/E Math

2020

EPS = 313 / 69

EPS = 4.53

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PE = 70 / 4.53

P/E = 15.45​

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Value Investing is all about finding stocks that are worth MORE than what they are selling for. Companies that have a high P/E are being sold for more than their actual value.

Why does P/E matter?

Open Ended

Think back to RBLX, INVE, and INTC. Which of these stocks are selling for more than their value?

Open Ended

So what about INTC? Does the low P/E mean it's a great buy?

Just because the P/E is low and the stock is cheap, doesn't mean the stock is on sale. It's only on sale IF it's worth more.

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A company that is growing, innovating, and increasing profits with a low P/E is on sale. A company that is stagnant without growth is cheap for a reason.

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Value Trap

So how do I know if the P/E is low or high?

It would be nice is P/Es followed the chart on the last slide, but they don't. A more accurate measure is to look at the average P/E by sector.

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Nothing is that easy...