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Course: Finance and capital markets > Unit 6
Lesson 4: Corporate metrics and valuationIntroduction to the price-to-earnings ratio
Price to Earnings Ratio (or P/E ratio). Created by Sal Khan.
Want to join the conversation?
- what's a good price to earning ratio?(43 votes)
- There's no "good" P/E, but 10-20 is usually considered fairly valued. <10 is usually considered undervalued and >20 is usually considered overvalued, though it really depends on the industry. Compare the company to its industry peers to determine if its P/E is fair.(66 votes)
- Around the 12 minute mark Sal discusses the P/E of a bank account versus a stock, as a means for comparing potential returns. Yet, if there is no dividend, how does a company's earnings translate into a return for the shareholder? It is clear that interest on a bank deposit is earnings that equate to a return, but w/o dividends how does this work for a stock?(24 votes)
- In today's world only the most established of companies (the Fortune 500 companies like GE, IBM, Microsoft, etc) pay a dividend. Stocks of non-dividend-paying companies are priced according to the public perception of future value. Their shareholders demand that the company will re-invest their profits (net earnings) wisely, in activities that expand the company's future profits. If the company continues to grow its profits, the stock price will continue to go up. So, because the PE is based on "net earnings" rather than dividends, the PE will adjust itself to the profitability... at least in a rational and fully informed market.
Many wise investors (Warren Buffet, for instance) will not invest in a company that does not pay a regular dividend. However, paying a dividend is like admitting that you have no lucrative way to expand, that you have reached the limit of your potential, and re-investing in yourself is not the best use of your profits.(54 votes)
- I'm confused about how to calculate the P/E ratio for say Apple. According to his example you would do Price divided by Earnings Per Share.
His numbers were 3.50/.35 giving a P/E of 10. According to google finance the P/E of Apple is currently 12.99. Apple's stock price is 456.19 and its most recent EPS were 13.87. But 456.19/13.87 gives a PE of 32.9 which is more than double the stated PE. What am I doing wrong?(11 votes)- If you look on Google finance or Yahoo finance, it says EPS is 35.11. This is the total EPS for all four quarters or in other words EPS for a year. So the P/E= 456.19/35.19= around 13.
You are just looking at the most recent EPS and that is why you are not getting the correct PE. If you add all the earnings, 13.87 7.05 7.79 6.40 (data from google finance), the total EPS would be $35.11. I am new to this topic too, I hope I answered it correctly.(47 votes)
- why people says that,"dont believe in P/E " ? Is that a correct statement ?(3 votes)
- It's not quite like "I don't believe in Fairies" -- clearly P/E does it exist. But many people don't think they tell you enough about a company.
For example Googles P/E is 19... whereas Exxon's is 9.5 and Apple is 15... which is cheaper... only time will tell!
This is because what investors are willing to pay depends on what they think they will earn in the FUTURE - not what they earn right now. So the fact that Google's P/E is so high suggests that people think they will grow, whereas Exxon's suggest that the market consensus is that it won't grow much at all...(18 votes)
- So does the stock price determine market capitalization, or does market capitalization determine the stock price? If stock price determines market capitalization, then who/what exactly determines the stock price?(3 votes)
- Market cap is totally determined by share price, and merely gives you an idea how big the company is. Share price is determined by what people are willing to buy or sell the shares for. That willingness is determined by a plethura of factors, many of which are irrational (fear and greed) in the short term. Over the longer term (years) the share price is determined by the company's actual performance, but always impacted on a day-to-day basis by the irrational issues(6 votes)
- Isn't the E/P ratio known as the Earnings Yield?(4 votes)
- The earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the company.
Read more: http://www.investopedia.com/terms/e/earningsyield.asp#ixzz1lvJqUEQa(3 votes)
- He says that the lower the P/E is, the better because you're paying less to get the same. However, later in the video he says that the price could drop from 3,50 to 1.5 and then the P/E would go from 10 to 5, which he says is bad. But I thought that the lower P/E, the better?(3 votes)
- Low P/E is better if the growth rate in earnings is the same.(4 votes)
- I see there are few companies which have more book value than the market value, so is the market undervaluing them? can we invest in those companies?(2 votes)
- The accounting could indeed be wrong, or management could be so horrible that the market thinks they're going to squander their money and lose shareholder value. In the latter case they could be a good target for a corporate takeover.(2 votes)
- How important is P/E when considering which stocks to buy?(2 votes)
- So if the earnings to price ratio is 10 when you buy a stock and then in later goes down to 5, does that mean you lost money even though an p/e of 5 is really good?(since the % return is around 20%)(1 vote)
- If the earnings didn't change and the PE fell by 50% that means that the thing you paid $100 for can now be sold for $50. Most people will interpret this as "I lost money" but of course you still own the same thing you owned before, it's just that now if you want to sell it RIGHT NOW you won't get your $100 back.
If you were happy to buy the thing at a PE of 10, you should want even more when the price falls to a PE of 5, unless something else happened that makes the thing worth less to you than it was before.(3 votes)
Video transcript
My son has been successfully
subdued, so I think this is a good time to learn about the
Price to Earnings ratio. And a lot of times you'll
hear people talk about a stock's P/E Ratio. And it's all the same thing. It's just a faster
way of saying Price to Earnings ratio. So let's think about the Price
to Earnings ratio of the company in question, this widget
case study, I guess you could call it, that we've
been dealing with. Let's say that the market
value-- we talked before that the book value per share
of this company is $5. Because the book value of its
equity is $5 million. And there's 1 million shares. So 5 million divided
by 1 million is $5. But let's say that the market
price, let's say that this is Widgets Inc. and let's say
that its ticker symbol is WINC, for Widgets Inc. And its
price is, it's trading at-- let me make up a good
number-- let's say it's trading at $3.50. And then we learned in the first
video that a price by itself doesn't tell
us a whole lot. So how may shares are there? We know there's a
million shares. So the market cap, or what the
market perceives the value of this equity is, the market
capitalization, is these two numbers. If we have a million shares,
then each of them, the market is saying, is worth $3.50, then
the equity of the company is worth $3.5 million. And this is the market value of
the equity, what the market thinks the equity's worth. So this is interesting. In our case, the book value of
the equity was $5 million. But the market is saying, no,
no, I don't necessarily believe those accountants. Maybe they're throwing some
stuff in here that's not really there. So we say it's only worth
$3.5 million. In this case, the company's
trading at a discount to its book value. And I won't go into detail on
that now, but that's actually a fairly unusual circumstance,
unless people are very suspicious about the accounting
or the actual book value of the company. Or if they think that this is
just a kind of an asset with a useful life that has
been shortened. If you owned a bunch of video
stores, then all of a sudden you say, I have $10 million of
video stores, and then the next day someone makes on-demand
videos there, all of a sudden, maybe your assets
aren't worth what you thought they were before. But we'll talk a lot more about
that when we deal with real examples. But in this case our market cap
is below our book value. And you can even look at
it from the price. I said the price doesn't
tell you much. But it tells you a decent
bit if you think of things in per-share. Because we know that the book
value per share is $5. The price per share, the market
price per share, is $3.50, so you could also
say it's trading at a discount to book. Now, what were the earnings
of the company? Well it was making $0.35. So let me write this down. Earnings was $350,000 in 2008. And let's just say we're looking
this from the vantage point that 2008 has happened. This isn't like I'm at the beginning of 2008 and modeling. So let's say we're looking at
this on January 1, 2009. And let's say the company has
already released its earnings, although it normally
takes a lot longer. Probably closer to
45 to 90 days. But let's say they released
their earnings. So we say, oh this company
made $350,000 in 2008. Or another thing that you might
see a lot when you look at companies, is that this is
trailing 12 months earnings. You'll see this TTM sometimes. Because when someone says
earnings, are those the earnings last year? Are those the earnings
that you're predicting for next year? So this is trailing 12
months earnings. And if you want to look at
earnings per share, EPS, is this number divided by the
number of shares was $0.35. So first, just to learn what
the Price to Earnings ratio is, let's just calculate it. Then we can talk about what it
actually means and if we have time, we can have a discussion
on why a company might have a higher or lower Price
to Earnings Ratio. And that discussion can actually
get quite involved. But in this case, you literally
just take the price of the stock and you divide it
by the earnings per share. So let me switch colors just
to ease the monotony. The Price to Earnings ratio
is equal to the price-- so $3.50-- divided by the
earnings per share. Divided by $0.35. So in this case, the Price
to Earnings ratio is 10. What does that tell you? well there's a couple of
ways to think about it. One is, you could kind
of flip this. No-one ever talks about the
Earnings to Price ratio, but that's an interesting thing
to even think about. Because it connects it with
a lot of other financial concepts that are out there. So this is kind of a Sal special
ratio, but it's a useful one to think about. The Earnings to Price ratio is
just the inverse of this. 0.35:3.50, which is
equal to 1/10. Or 10%. And so the way to think about
it is if you're paying $3.50 per share for this company, and
let's say the company next year-- so this is trailing
12 months earnings. But let's say this company, for
whatever reason, it's a really stable company. It's doing the same
thing every year. It's not growing. It's not shrinking. Let's say that not only is this
the trailing 12 months earnings, but this is also--
actually, I'll introduce terminology right here. So this is trailing 12 months. You could also have
forward earnings. What are forward earnings? You can probably guess. The earnings I just said, this
is actually what happened to the company. This was the earnings of
the company last year, or the last 12 months. Forward earnings are, you know,
there's a bunch of guys with MBAs and CFAs working for
the banks, and they write research reports. And they model the company. They meet with the company. They analyze the industry. And if they're good analysts,
they'll come up with a number. They'll say, I think
this company is not going to change. It's such a super
stable business. They're going to make $0.35
in 2009 as well. So in this case, this would
be the forward earnings. And usually if it's a
well-followed company, there might be 10 or 15
or 20 analysts. And what they do is they average
out all of the numbers from all of those analysts. And then if the average is,
let's say, $0.35, they'll call this the consensus. So the consensus is just the
average of all of the sell side analysts out there. And maybe I should do a whole
video on what sell side means, but since I said the word
I'll tell you right now. Sell side are like the
investment banks and the research houses. And the reason why they're the
sell side is because they're always selling you stuff. They're selling you stocks. They're brokering
transactions. They write these research
reports because they want to go to institutional investors
or people who have their brokerage accounts with these
banks, and essentially sell them stock. Say hey, you should buy Widgets
Inc, because it's only trading at a Price to
Earnings of 10. And we really like it. It's much better than buying
treasury bonds right now, because you're making
more money on it. You're making 10%, and that's
just to connect the dots. Price to Earnings of 10. If it's stable, you're making
the equity will grow in this coming year by 10%. And that's better than what you
get out of treasury bonds. So that's what sell
side means. So a sell side analyst
is someone who publishes these reports. A buy side analyst is someone
who works for a hedge fund or works for Fidelity
at a mutual fund. Or works for an endowment
or a pension someplace. And they're managing other
people's money. And they're trying to figure
out if they can believe what's happening. So they're going to do
their own analysis. So that's what the
buy side is. Those are the people who are
actually managing money and deciding what they want to
invest the money in. The sell side are the people who
do analysis and say, hey due to my analysis isn't
this a good stock? Don't you want to buy
or sell this stock? So fair enough. That was a bit of a diversion. Anyway, going back to Price to
Earnings, we calculated the Price to Earnings. It was 10. But the reason I wanted do to
Earnings to Price is because it connects it back to things
like yield and interest. I can do a Price to Earnings
on my bank account. Let's say in my bank account
I have $100. So this is a diversion
right here. So let's say I have $100
in my bank account. And over a year I make 2%
interest. Let's say it's guaranteed 2%. Maybe it's in the CD. So I have $102 at the
end of the year. This 2% were my earnings. So I made $2 of earnings. So the way to think about a bank
account is, well how much do I pay for that
bank account? Well in this case I paid $100
for the bank account. So the price would be $100. And the earnings on the
bank account in that year were $200. So it has a Price to
Earnings of 50. Or if you do the Earnings
to Price, if you do $2/$100, you get 2%. Which is normally how we think
about bank accounts. We say, oh I'm making 2%
interest on that bank account. Now, this actually leads to a
very interesting question. If a bank account only gives
me 2% on my money, and this company is arguably giving me--
assuming that it's stable and I believe the consensus--
it's giving me 10% on the money, why would I even hold
this bank account? Why wouldn't I just pour
all of my money? Why am I willing to pay a higher
Price to Earnings for the bank account than I
am for this company? And I think you already get the
sense that the lower the Price to Earnings, all else
equal-- and that's a big thing-- all else equal, the
lower the Price to Earnings, you're paying less
for something. You want to have a lower
Price to Earnings ratio for the same asset. Because you're getting the same earnings for a lower price. But when you lower the Price to
Earnings you are increasing the Earnings to Price. So you would increase
your yield. You want to maximize
this number. But I'll finish this video with
kind of a basic question. Why would someone ever keep
their money in the bank at 2% or a Price to Earnings of 50,
when they could have a Price to Earnings of 10 with
Widgets Inc.? And the answer is because
this is very uncertain. Who knows what happens
with Widgets Inc.? Maybe all of these guys
were-- Maybe this is a big Ponzi scheme. I mean, most companies in
this country aren't. And that's another thing to talk
about, is country risk. Because even though you're
probably suspicious of them now, the US has some of the
most transparent companies with some of the best accounting
standards. If this was in-- you know,
I don't want to state any countries because people all
over the world listen to these videos-- but if it were a
country with less solid accounting standards, you would
be like, they might be making up all of their numbers
so I don't trust it. Or you might say, you know,
Widgets Inc., even though the analysts are saying that they're
going to make $0.35 this coming year, you might
say, you know, I don't believe that. I think there's actually a lot
of risk in Widgets Inc. That there's actually more volatility
here than anyone gives credit for. They might go out of business. There's a strong competitor. There's a lot of
risk involved. And the other thing is,
even if you don't think there's risk. Even if you think that this
company's going to make $0.35 forever, the other reason why
you might prefer to have a bank account over Widgets Inc.
is because you're guaranteed to get $102 back for your bank
account at the end of the year if you wanted. Assuming this is a CD with
a one year duration. You're guaranteed to get your
$102 back, especially if it's FDIC insured. But in this case, even though
the earnings might be the same, something horrible might
happen to the markets and everyone just dumps their
stocks, money flows just run outside of markets. And for whatever reason people
get scared, and the price could go down a lot
from $3.50. It could be very,
very volatile. And this thing, maybe the price
goes from $3.50 to $1.75 a year later. Which it seems like a really
good deal, because now the Price to Earnings is $1.75
divided by $0.35, would now be a 5 Price to Earnings. But this could happen. I mean, companies go from a 10
to a 5 Price to Earnings. And then all of a sudden, if
you want that money, if you need that money a year later,
you've lost half of it. So there's some volatility in
the price even though you're assuming that the earnings
are stable. So that's a little bit of a
taste of why someone might realistically, in this case, pay
a higher Price to Earnings for safety. Safety because you know that
this earnings stream is guaranteed. And liquidity. Liquidity because you
know you're going to get your money back. That you're going to be able to
essentially sell your bank account and get cash for it. And you know that it's
going to be $100. That there's no volatility
in price. Well in this case, you're
uncertain about the earnings stream. You're uncertain about what the
market will be willing to value it at a year later. And frankly, you might
be uncertain about liquidity in general. Maybe this is a really small
company and not a lot of people trade in it. And you might not even be able
to find anyone to buy it a year later. The epitome of an illiquid
asset is maybe a really expensive $20 million house. Even though it might be worth
$20 million, a year later you might not-- there are only so
many people who can afford a $20 million house. So it's an illiquid asset. Anyway, I want to
leave you there. In the next video we'll go into
more depth on Price to Earnings ratio, and think about
things like growth and stability and whatnot.