Value Investing: PE Ratios

cryptomeeks(53)

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Prelude

There is a mass shift taking place in the financial industry. What used to be an industry monopolized by advisors and stock brokers, is now transforming into an open and (almost) even playing field. In a world where fees were almost unavoidable, now is a world where you can trade multiple financial assets commission free. Rather than paying for proprietary advice, you have knowledgeable people now all over the internet giving educated opinions and advice all for free.

However, there is still a huge learning curve involved with investing. The lay investor just getting started doesn't know what to invest in, and at times, it just becomes a crap shoot. These apps like Robinhood allow free trades and investing, which is great, but it is almost too easy. You can start making moves with your money without knowing what you're doing. It is very common for someone to try investing for a year or less and eventually just give up. The common reasons for this are: impatience, the lack of knowledge, and the lack of emotional control.

The lack of knowledge is the easiest to be a victim of. I've been in situations where I thought I knew everything. However, when it comes to investing, there is a lot of bad information out there. People attempting to make predictions on price movement, People hyping up a stock they have made money on, and people who just want to bait you into reading their content. I guess the lack of knowledge isn't the issue, but the lack of the correct knowledge. Put briefly, you need to know the basics of evaluation companies and the current state of the economy on your own. You will never be a successful investor if you are listening to news sources about economics and money. It's all noise that only blurs your financial vision.

Impatience occurs when an investor is stuck in the short-term frame. Focused on quick gains, doing little research on companies and investments. This causes a self-feeding cycle of loss of capital and a physical and emotional toll on the person, seeing their money leave their hands.

The lack of emotional control is the absolute hardest to fix. This comes down to your temperament and psychology. If you have too much of a chip on your shoulder, you'll be dead set on making huge gains in small chunks of time. If you are depressed, you will lack confidence in yourself. If you are too confident, it will cause you to make decisions that the more cautious you would wait and watch play out first. Emotions can throw a wrench in a lot of facets of your financial strategy and it is important that you take an indifferent approach to your finances and investing.

I can't teach you to control your emotions, and I can't teach you patience. These are virtues. However, I can do my best to give you bite sized knowledge that you can implement in your financial strategy for your own success.

There are a few different categories of knowledge that you should consider building up:

Fundamental
Technical
Economic

Today we will focus on fundamentals.

Let's get started.

PE Ratios: Evaluating a company on it's Earnings

Benjamin Graham, the mentor of wildly successful investor, Warren Buffett, is known to many as a value investors. Value investors ignore charts, hype, and financial news networks. They only care about company financial statements. These statements include income statements and balance sheets mainly.

Income statements, put simply, show how much a company is bringing in each month, whether that's a gain or loss.

Balance sheets show a company's assets and liabilities. An asset can be property, equipment, and sometimes financial assets such as accounts receivable or cash. These assets are seen as things that can bring in more income quarter to quarter, or something that can be sold during bad times (though the best companies shouldn't need to). Liabilities are most commonly debts that the company is obligated to pay.

So how do we calculate a PE Ratio?

For any company that you actively research, the PE Ratio of that company will be readily available. However, it is important to know how to calculate a PE ratio to better understand them.

There are two components of a PE Ratio:

Market Price
Earnings

Market Price is determined by the exchanges that the asset is traded on. If it is a stock it would be the New York Stock Exchange or the Nasdaq.

Company Earnings are determined by taking the net profit (Revenue - All expenses) and subtracting that number with the dividends payed out in the same time period. These dividends are paid to the shareholders, but eat into the profitability of the company. You then take this number and divide it by the number of total shares outstanding.

Again, all of this information is almost always calculated for you, but it is good to know.

You then take the market price and divide it by the Earnings.

Let's say for this example, ABC stock is priced at $100 per share. It has quarterly corporate earnings of $8.00 per share.

$100 per share / $8.00 per share = 12.5

ABC company has a PE ratio of 12.5

How do I tell what is a good and bad PE ratio?

In Benjamin Graham's book, "The Intelligent Investor" He talks about the right way to evaluate a company. He gives his opinion about what constitutes an undervalued company and an overvalued company. There are many facets on how to properly value a company, but today we are only focusing on PE Ratios.

Graham states that an overvalued company has a PE ratio greater than 25. For an company to be considered undervalued in terms of earnings, it should have a PE ratio of less than 10.

Investors typically use this rule of thumb to determine whether a company is under or over valued.

It's not an end-all-be-all method, but it is a handy tool to use.