One of the biggest problems with Investing is that we have to sacrifice a portion of our earnings in order to gather some money to invest and many people find that hard.
In this blog post, I want to explain certain aspects of investing and try to address certain hardwired autosuggestions that come to our mind when we approach investing in general and then talk about some commonly used terms in investing that will help you understand this space.
I will use a questionnaire approach to make it a bit interesting. I will sprinkle some questions along the way in order to explain this topic. Let’s begin by taking an example:
Suppose you were going to buy a new MacBook pro worth $5000 and I suggested you to go for a refurbished one which might save you about $1500 and then this money can be used for investing.
You were going to go for a vacation this year and spend about $5000 during the vacation and I suggested you not to go this year and invest this money instead.
Question 1: Would you do it? What would be your instinctive response or instinctive thought process?
I am not sure about what most people will think but let me try to answer what I would have answered to such a suggestion….
My response in case of the vacation: I have toiled hard and earned this vacation and the experiences this $5000 would bring me would anyway be invaluable…but since we started this conversation I might start to think about the returns on this $5000 if I invest this money and an automatic question will spring up in my mind which would be something like this:
Question 2: If instead of going on vacation I invest this money, how much return on this investment would make me rethink my vacation plan?
Now, since we are having a conversation, I would like you to come up with a minimum number in your head to answer that question. This number can be any ridiculous number or very reasonable.
Let’s assume, your answer was $50,000 i.e. if you are able to get an investment return of 10 times on your $5000 in 10 years, you will be willing to reconsider your plan.
Now, many of you might think that it is very unlikely for this to happen so let’s go on the vacation since we have our answers. But I want to present a different side of the story and back it by numbers.
Let’s take example of a 20 year old uni graduate who was planning to go on this vacation but instead decides to invest. According to his assumptions since his money is going to become 10 times every 10 years, somewhere down the line, say after 40 years from now the number will look something like this:
But since we are aware that likelihood of this happening are very slim but the fact that I wanted to establish was the power of compounding. Not many people reading this would have thought that $5000 compounded for a longer period of time at a good rate can give amazing yields if not $50 million as shown in this example.
We will revisit this example later…but first we should discuss a very important concept that comes up very frequently when we start talking about investing and this concept is actually a ratio called as the P/E ratio.
P/E Ratio or Price/Earnings ratio
In very simple terms price to earnings ratio tells the investor that how much money he/she should invest in a company in order to make $1.
For example, as of May 13, 2019 Apple PE ratio is 15.5. This means that in order to earn $1 at the end of the year you will have to invest $15.5 in Apple. If you want to translate this to percent returns then you can calculate this simply as follows:
100/15.5 which is 6.4% approx. return on investment.
That was the crux of P/E ratio but if we want to truely understand P/E of a stock we can do the following:
Let’s say the price of Apple share is $185. So the value for P(price) for this ratio is $185, now if I ask you what is the earning for this share, many people answer that it’s the dividend(distributed earnings) that the company distributes but that is not the correct answer.
The earnings value that we are interested in is the total sum of distributed earnings and reinvested earnings i.e. total earnings/net income that Apple inc made. But we are not interested in the total earning that Apple made, instead we are interested in earnings per share(EPS). So in this case:
EPS = Total Earnings / Total number of shares.
For FY 2018, total earnings after paying taxes, operational costs and paying dividends was $56,374,937,600 ($56.37B)and number of shares were 4,715,280,000(4.71B).
So EPS as of 2018 was $56,374,937,600/4,715,280,000, i.e. $11.95. Hence if the value of share is $185 then the P/E would be 185/11.95 = 15.48.
This means that you will get $1 for every $15.48 that you invest in Apple inc. or in other words you can expect a 6.45% return on investment.
Since we know now what is P/E ratio of a company but can we really rely on P/E ratio to make a decision to either buy share or not?
The answer to question asked above is NO because we compare P/E ratio of a company with some other things to make a buying decision.
Let’s try to answer that why can’t we just trust the P/E ratio of a share to make a buying decision with help of a similar example. Let’s take example of a smaller company with total earnings of $1B and total shares in the market to be 5million and share price of $1000. Now the P/E ratio of this company would be Price of one share/ Earnings per share ($1B/5Million shares = $200), which is:
$1000/$200 = 5, i.e. the buyer gets $1 for every $5 invested in this company which equates to 20% return on investment.
Now if I ask you which company would you pick based on the P/E value? The obvious answer is Company A over Apple. But is that the right choice?
Let’s find out…
P/E ratio is not an absolute number, instead it is a comparative number.
Let’s assume everything else other than the P/E ratios of these two companies(company A and Apple) is the same, then where would you like to invest your money? In this case, the obvious answer would be company A but this does not happen in real life scenarios and people tend to give more premium to companies like Apple even when there are companies with lower P/E values available in the market.
By premium, in this case I mean the extra $15.48 – $5 = $10.48 that the investor is paying to Apple.
Question: What makes investors spend this extra money on a company?
One big reason is the future value of the $1 return on investment that Apple inc. promises in return of $15.48 investment. The probability of this earning going up in case of Apple is way more when compared to Company A because of N different reasons. These reasons can be stable revenue sources, amazing management, strong Moats etc. and it is because of this belief in Apple inc. that people tend to pay more premium. Or in other words, this investment is more secure and the risk on this investment is very well balanced whereas the risk on the investment with Company A is more.
From the example above we can come to a conclusion that P/E ratio does not tell us anything about the future visibility of our investments and is restricted to just provide an estimate on the current investment value and this is why we should not make investment decisions by just looking at the P/E values alone.
Other issues with P/E
P/E ratios can also misinform us about the value of a share or return on investments on a share. Let’s take an example:
Suppose a company A and company B are very comparable in almost all aspects of there businesses but when we had a look at the price per share of Company A it was trading at $80 with a return of $8 and when we had a look at company B it was trading at $80 with a return of $40. In this case, even though both the companies are comparable the P/E ratios differ dramatically.
Company A (P/E) = $80/$8 = 10
Company B (P/E) = $80/$40 = 2
In this case, company B becomes the obvious choice for investment since P/E ratio is a lot more than company A. But, this might have happened because of a one time expenditure by company A for expansion of the company which reduced the earnings or it might be because of some one time sudden payment to company B because of some sale in holding which bumped the earnings for last year to extra ordinary levels.
So crux of the explanation is that P/E ratio is not a reliable source to measure the price of a share in the market.
How to use P/E ratio
Since we have now established that P/E ratio is flawed in certain ways, then why do we even bother checking its value? or how/when to use the P/E ratio?
I will answer this very important question in my next blog. Till then please feel free to leave a comment and let me know if you enjoyed reading this article.
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