PE Ratio Explained (With Examples)

Summary

This video explains the Price-to-Earnings (PE) ratio, a key metric used to determine whether a company is overvalued or undervalued. A lower PE ratio typically indicates a cheaper stock, while a higher PE ratio suggests a more expensive one. However, simply picking stocks with low PE ratios can be misleading. The video demonstrates this through practical examples, including comparisons between McDonald's, Coca-Cola, and a fictional bakery business. It also introduces the concept of earnings growth, showing that companies with higher PE ratios but stronger earnings growth may still be better investments in the long run.

Takeaways

• 📊 The PE Ratio (Price to Earnings Ratio) shows how cheap or expensive a company is, with lower PE ratios being cheaper and higher PE ratios being more expensive.
• 📉 The PE Ratio is calculated by dividing the price per share by the earnings per share (EPS), with the EPS number typically representing earnings over the past 12 months.
• 📈 In a simple example, a lower PE Ratio indicates a better value for investment as it provides more earnings for the same price compared to a higher PE Ratio.
• 💰 Net income (earnings) is the most important figure when evaluating a company's profitability, as it reflects the money left after all expenses and taxes.
• 🏪 The PE Ratio concept applies both to entire businesses and individual shares of stock. Lower PE ratios imply buying earnings at a cheaper price.
• 🔍 A lower PE Ratio means a higher return on investment (ROI), as it results in better earnings for the money spent. For example, a bakery with a PE Ratio of 5 will pay for itself in 5 years.
• 📉 Comparing stocks like McDonald's and Coca-Cola, lower PE Ratios might suggest a better deal, but other factors like growth rate should also be considered.
• 🚀 Earnings per share (EPS) growth rate is a critical component when evaluating investments, as companies with higher growth rates can be better long-term investments despite having higher PE Ratios.
• 🕵️ A company with a higher PE Ratio might still be a better investment if its earnings grow faster over time compared to a company with a lower PE Ratio.
• 📚 The PE Ratio should not be the sole factor in investment decisions. It’s essential to consider both the current earnings and potential growth when evaluating stocks.

Q & A

What does the PE ratio represent in stock valuation?

The PE ratio (Price to Earnings ratio) represents the price of a stock relative to its earnings. It is calculated by dividing the price per share by the earnings per share (EPS). A lower PE ratio suggests a cheaper stock, while a higher PE ratio indicates a more expensive stock.

How is the PE ratio calculated?

The PE ratio is calculated by dividing the price per share of a stock by its earnings per share (EPS). For example, if a stock's price is $21.73 and its earnings per share are $6.31, the PE ratio would be 33.5.

Why is a lower PE ratio generally considered better?

A lower PE ratio is considered better because it means you are paying less for each dollar of earnings. In simple terms, you're getting more earnings for your investment. For example, a company with a PE ratio of 5 is considered cheaper than one with a PE ratio of 10.

What does net income refer to in business valuation?

Net income, also called earnings or net profit, refers to the money left after all expenses and taxes have been paid. This is the actual profit that can be distributed to shareholders or reinvested into the business.

How does the PE ratio apply when buying a whole business, like the bakery example?

When buying a whole business, the PE ratio still applies. For example, if a bakery has $50,000 in annual earnings and the business is priced at $500,000, the PE ratio would be 10. A lower PE ratio, such as 5, would mean you are paying less for each dollar of earnings, resulting in a better return on investment (ROI).

How does the PE ratio affect return on investment (ROI)?

The PE ratio directly affects ROI. A lower PE ratio indicates that you are paying less for each dollar of earnings, which results in a higher ROI. For example, buying a business at a PE ratio of 5 provides a 20% annual return, while a PE ratio of 20 would provide only a 5% return.

Why is it important to consider a company’s earnings growth rate in addition to its PE ratio?

While a lower PE ratio may indicate a cheaper stock, it's also important to consider the earnings growth rate. A company with a higher PE ratio but a faster growth rate may provide a better long-term return than a company with a lower PE ratio but slower growth.

How does earnings growth affect long-term stock performance?

Earnings growth significantly affects long-term stock performance. For example, a company growing its earnings by 10% annually will have much higher future earnings than one growing at 5%. Over time, this can lead to a higher stock price, making it a better investment despite having a higher initial PE ratio.

Can the PE ratio be used to compare companies in different industries?

While the PE ratio can help compare companies, it’s not always accurate to use it across different industries. Some industries have naturally higher or lower PE ratios due to differences in growth rates, risks, and capital requirements. It's better to compare companies within the same industry.

What are some limitations of relying solely on the PE ratio for investment decisions?

Relying solely on the PE ratio can be misleading because it doesn’t account for important factors like earnings growth potential, business risks, or industry-specific characteristics. A stock with a low PE ratio might still be a poor investment if the company's earnings are declining or if it faces significant risks.