In my previous blog we discussed about the P/E ratio, EPS(Earnings per share), power of Compounding etc.
I will start this post by answering the following question:
How/When to use the P/E ratio even when we know that it can give flawed outcomes?
To answer the question, we have to first think about the bank rate of returns. So, take a moment and try to check how much will the bank give you for a term deposit or a fixed deposit. In the current scenario, the best term deposit rates that the banks are offering are about ~3% approx. for a term deposit. Now, try to calculate the P/E for the term deposit using the formula discussed in previous article:
P/E ratio = Price / Earnings
So, in this case to calculate the P/E for Bank Term deposit(TD), the P/E ratio will be:
P/E (for Term Deposit)= Amount deposited in TD / Earnings on TD
Suppose I invested $100 in TD for one year at 3% p.a. My earnings after a year will be $3. So P/E for this TD = 100 / 3 = 33.33
In other words, I had to deposit $33.33 in the bank for one year in this TD to make $1.
Comparing P/E for different options
Let’s now compare this 33.33 with the return that was calculated for Apple in the previous article.
In today’s market as of May, 2019 the P/E for Apple stock is somewhere close to ~15.
It is clear from the comparison above that as of today, return on investment with Apple is more when compared to the Bank but there is a component of risk involved when it comes to investment in stocks.
Why will money invested in good companies grow?
All entrepreneurs work to generate more average returns when compared to the bank.
Let’s take example of an imaginary scenario. Suppose Apple decides to sell all the assets it owns and invest all the money it generates from this sale in the bank term deposit(TD).
Can you imagine how much money would Apple like to generate with this investment?
At the minimum, bank will give Apple the same return on investment that it gave for a normal term deposit which was 3%.
So, if without doing anything and just by investing the money with Bank, Apple can get maximum returns that Bank has to offer (be it 3%, 5% or 7%). Why isn’t Apple or any company doing it?
I will leave the answer to this question up to your understanding of the topic 🙂
In the upcoming articles, I will discuss about some fundamental rules of investing, Index funds, GDP, Dow theory and much more. Till then please feel free to leave a comment and let me know if you enjoyed reading this article.
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Disclaimer — The information in this Blog and the links provided are for general information only and should not be taken as constituting professional advice from the author — Navdeep Singh.