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Current time:0:00Total duration:14:47

Video transcript

my son has been successfully subdued so I think this is a good time to learn about the price to earnings ratio price to earnings ratio price to earnings ratio and a lot of times you'll hear people talk about a stock's pde ratio ptooie 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 company that we've been this widget case study I guess we 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 five dollars because the book value of his equity is five million dollars and their five million share there's 1 million shares so 5 million divided by 1 million is 5 dollars but let's say that the market price let's say that this is widgets Inc and let's say it's it's its ticker symbol is W I and C for widgets Inc and its prices it's trading at let's say it's trading at let me make up a good number let's say it's trading at $3.50 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 many shares are there we know there's a million shares shares there's 1 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 in each of them the market is saying is worth 350 then the company or the equity not the company the equity of the company is worth thirty five no three point five million dollars so let me write it out three three point five million dollars and all right this is this is the market value of the equity what the market thinks the equity is worth so this is interesting in our case the book value of the equity was five million dollars but the market is saying no no you know I don't necessarily believe those accountants maybe they're throwing some stuff in here that's not really there so we're going to where we are we say it's only worth three and a half million dollars in this case the the company is trading at at a discount to its Book value and well I won't go into detail on that now but that's actually a fairly unusual circumstance unless you're 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 a an asset that is kind of I guess the best ways it's it's it's useful life has been shortened you know if you own a bunch of video stores and all of a sudden and you know you say I have 10 million dollars of video stores and then the next day someone makes you know on-demand video is there all of a sudden you know 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 with real examples but in this case our market cap is below our book value and you can even look at just from the price I said you know the price and 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 dollars the price per share the market price per share is three dollars and 50 so you could also say oh it's trading at a discount to book now what were the earnings of the company well it was making 35 cents so let me write this down so it's earnings earnings was 350,000 dollars in 2008 and let's just say we're looking this we're looking at this you know from the vantage point that 2008 has happened this isn't like I'm at the beginning of 2008 in and modeling and so let's say we're looking at this in on January 1 of 2009 and let's say the company has already released its earnings although that normally takes a lot longer probably closer to you know 45 to 90 days but let's say they already released their earnings so we say oh you know that this company made $350,000 in 2008 2008 or another thing that you might see a lot when you look at companies is that this is the trailing this is trailing 12 months earnings you'll see this TTM sometimes because when someone says earnings are those earning 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 so earnings per share EPS is this number divided by the number of shares was 35 cents so first just to learn what the price to earnings ratio is let's just calculate it and then we could talk about what it actually means and and if we have time we can have a discussion on on why a company will 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 the price term let me switch colors just to ease the monotony the price to earnings ratio is equal to the price so three dollars and 50 divided by the earnings per share divided by 35 cents so in this case the price to earnings ratio is 10 what does that tell you well there's 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 think about because it connects it with a lot of other financial concepts that are out there so let's just this is not a this is kind of a you know a Sal special ratio but it's it's a it's a useful one to think about the earnings to price ratio is just the inverse of this 0.35 - 350 which is equal to one tenth or ten 10% and so a way to think about it is is if if your cut if you're paying 3.50 per share for this company and let's say the company next year so this was their earnings 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 forward earnings what our forward earnings you could 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 month forward earnings are you know there's a bunch of guys with MBAs and CFA is working for the we're 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 you know what I think this company is going to make well they might say I think this company's not going to change it's such a super stable business they're going to make 35 cents in 2009 as well as well so in this case this would be the forward earnings and usually if it's a well followed company there might be ten or fifteen or twenty analysts and what they do is they average out all of the numbers from all of those analysts and then if the average is to say 35 cents they'll call this the consensus so the consensus is just the average of all of the sell-side analysts out there and I'll 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 at 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 percent and that's just to connect the dots you know priced earnings of 10 if it's stable you're making every year the equity will be growing at least or this coming year it'll grow by 10% and that's better than what you get on a Treasury bonds so that's what sell side means buy side so a sell side analysts is someone who publishes these reports a buy side analysts is someone who works for a hedge fund or works for fidelity in a mutual fund or works for an endowment or pension someplace and they're managing other people's money and they're trying to figure out if these analysts make you know 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 in deciding what they want to invest the money and the sell side are the people who do analysis say hey do 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 a diversion but anyway going back to price to earnings we calculated the price to earnings it was 10 but I reason wanted to do earnings to prices because it connects it back to things like yield and interest and and you know like if I have a you know I could do a price to earnings on my bank account let's say in my bank account I have let's say in my bank account I have $100 so this is a diversion right here so bank account bank account so let's say I have $100 in my bank account and over a year I make 2 percent interest let's say it's guaranteed 2 percent maybe it's in a CD so I have 102 dollars at the end of the year this 2% were my earnings right so I made 2 dollars over earnings two dollars or earnings so the way to think about a bank account is well how much do I pay for that bank account well I paid 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 $2.00 so as a price to earnings of 50 price to earnings of 50 or if you do the earnings to price if you do 2 dollars over $100 you get 2 percent which is normally how we think about bank accounts we say oh I'm making 2 percent interest on that bank account now this actually leads to a very interesting question if a bank account only gives me 2 percent on my money and this company is arguably giving me assuming that it's stable and I believe the consents is giving me 10 percent on the money why would I hold why would I even hold this bank account why would 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 right 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 lower price but when you lower the price-to-earnings you are increasing the earnings to price right so you would increase your yield right you want to maximize this number but I'll finish this video with with the kind of a basic question why would someone ever keep their money in the bank at 2% or at a price to earnings of 50 when they could get you know 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 the widgets Inc maybe all of these guys were you know maybe this is a big Ponzi scheme I mean not that you know most companies in this country aren't and that's another thing to talk about is country risk because we have even though you've you know 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 I don't want to state any countries because people all over the world listened to these videos but if it were a country with less solid accounting standards you like May they could might they might be making up all of their numbers so I don't trust it or you might say you know what widgets Inc their business is just very even though the analysts are saying this the analysts are saying that it's it's you know 30 they're going to make 35 cents this this coming year you might say you know what I don't believe that I think there's actually a lot of risk in widgets Inc that that these that there's actually more volatility here than anyone gives credit for and they might go into business there's a 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 people are always going to that this company's going to make 35 cents forever the other reason why you might want prefer to have a bank account over widgets Inc is because you're guaranteed to get 102 dollars back back for your bank account at the end of the year if you want it assuming this was a CD with a one-year with a one-year duration you'll get your hundred you're guaranteed to get your hundred and two dollars back especially if it's FDIC insured but in this in this case even though the earnings might be the same something horrible might happen to the markets and everyone just dumps their stock money flows just run outside of markets and for whatever reason people get scared and the price could go down a lot from 350 it could be very very volatile and and this thing might you know maybe the price goes from 350 maybe it goes to a dollar 75 a year later which it seems like a really good deal because now the price to earnings is a dollar seventy-five divided by 35 would now be would now be a five price earnings but this could happen I mean companies go from a 10 to a 5 price to earnings and their 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 of why the you know 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 a hundred dollars that there's no volatility in price well in this case you're not uncertain about the earnings stream you're uncertain about what the market will be willing to value it a year later and frankly you aren't you might be one uncertain about liquidity in general maybe this is a really small company not a lot of people trade in it and you might not even be able to find anyone to buy it a year later I mean that you know the epitome of an illiquid asset is of maybe a really expensive a twenty million dollar house even though it might be worth twenty million dollars a year later you might not just feel there are only so many people who can afford a twenty million dollar house so it's an illiquid asset anyway I wanted to leave you there in the next video we'll go into more depth on price to earnings ratio and and think about things like growth and stability and whatnot