The Price You Pay vs. The Value You Receive
When US equity markets are pushing ever higher, investors naturally begin wondering “what are the best stocks to invest in right now?” But, as with purchasing other goods, before investors consider what stock to invest in, they should consider what a desired stock is worth.
In an age of high-frequency trading and “meme” stocks, it is easy to forget the fundamentals; that a stock represents ownership in a company. Therefore, the value of a stock should be what the company will earn for its owners. Theoretically, the price of a stock should equal its value, but theory and reality seldom agree.
Determining the price of a stock is easy; anyone with access to the internet can immediately learn the price of a stock. Determining value is much more difficult because it requires forecasting the earnings of a company out into the distant future.
One of the most frequently used tools used by analysts to reconcile these two measures is known as the “price-earnings ratio.” At its core, it is a very simple concept, and is literally the current price of a stock, divided by its earnings:
This simple metric allows us to gauge the sentiment for a stock. Consider the following example:
 The devil is in the details when it comes to calculating earnings. Some people use the most recent quarter or year’s earnings. Another approach is to try to forecast earnings out in to the future and produce a “forward-looking” earnings estimate. Others will adjust a company’s earnings for accounting factors like interest, taxes, depreciation and amortization. Suffice to say, determining the earnings for the P/E ratio’s denominator is the hard part.
Stock A has a high price-earnings ratio of 25. That means investors are willing to pay a high price today for a company’s future earnings. In other words, investors are bullish on a Stock A. Conversely, Stock B has a low price-earnings ratio, which implies investors are not very excited about a company’s earnings. They aren’t very willing to pay a high price for that company B’s stock- i.e., a bearish outlook.
Does this mean Stock B is a bad investment? Not necessarily. Some investors look at the above numbers and see “value” in Stock B. In the eyes of a value investor, both stocks are offering up $10 of earnings per share, but Stock B allows you access to those earnings for a much cheaper price- $100 vs. $250.
Beauty, or in this case a good P/E ratio, is in the eye of the beholder. Some would argue Stock A is the better investment, others would favor Stock B. This debate is one of the fundamental conflicts in investing, the difference between “growth” and “value” investing, respectively.
We can also view the P/E ratio from a time standpoint. The P/E ratio tells us how many years of earnings we are purchasing at today’s stock price.
- If Stock A has earnings of $10 per share and the price is $250, the P/E ratio of 25 implies that today investors are paying for the next 25 years of earnings.
- Alternatively, Stock B’s P/E ratio of 10 means it will only take ten years of earnings in order to recoup the price of the stock today.
Today, many stocks are trading at P/E multiples of greater than 50, meaning investors are paying for earnings all the way out to the year 2071, or longer!