Investment Tips – Don’t Mistake a Low P/E Ratio for a Value Stock

This is the third in the series of investing tips that I’ll be discussing.  The latest copy of Forbes magazine has a list of 365 tips on investing to get rich.  I thought I’d go through some of the ones I found the best and expand on them to provide a more detailed discussion.

 

 

 

Investment Tips – Don’t Mistake a Low P/E Ratio for a Value Stock – What is a P/E Ratio?

First of all, you may be asking: “what is a P/E Ratio?”  Well, if you’re new to investing, I’ll give you a short explanation here.  The P/E ratio stands for the price to earnings ratio of a stock.  This is a pretty useful tool when comparing stocks from similar industries.  It is not as useful when comparing stocks from different industries, but we’ll get to that in a bit.

The P/E ratio is calculated in three steps:
1) Take the current market price of the stock.  As example example, we’ll use Intel (INTC).  It’s current market price as I sit here typing out this article is $25.46.
2) Next, multiply the current market price by the total number of shares outstanding.  This gives you the market capitalization of the stock (market cap).  For Intel, there are 4.98 Billion shares outstanding.  $25.46 * 4.98 Billion = a market cap of $126.79 Billion.
3) Now, we take the market cap and divide by the previous years earnings.  If you’re a super detailed person, you can find the company’s previous annual earnings in their 10K from the SEC website.  If you’re lazy, you can get this number straight from Yahoo finance under the “Financials” tab.

There you have it.  The current P/E ratio for Intel is ~13.73.  This means that investors are currently willing to pay 13.73 times annual earnings for this stock.

Investment Tips – Don’t Mistake a Low P/E Ratio for a Value Stock – Why is the P/E Ratio Useful?

The P/E ratio is useful because it can help you to sniff out good deals on stocks.  All other things being equal (yeah right, when does that ever happen?), if two companies are exactly the same, but one has a lower P/E ratio, this would be the one to buy because it is “on sale.”

So, in the previous section above we found that forIntel stock, the current P/E is 13.73.  If we’re in the market to buy a computer chip manufacturer’s stock, how would we go about deciding which stock would be the best value for our money?  Well, let’s see what the P/E ratio can tell us!  How does Intel’s P/E ratio compare to AMD, Qualcomm, ARM, Texas Instruments, and other computer chip manufacturers?  Check out the table below to see how the P/E ratio between these various companies stack up.

INTC	13.73
AMD	–
QCOM	18.59
ARM	99.14
TXN	25.48

As you can see, the company with the lowest P/E ratio is: INTC.  All other things being equal, this would be the best value for our money.  AMD doesn’t even have a P/E ratio because they are losing money!

Investment Tips – Don’t Mistake a Low P/E Ratio for a Value Stock – P/E Ratios and Value Stocks

But wait a minute, the advice from Forbes is to not mistake a low P/E ratio for a value stock.  How can this be?  Well, there are a number of reasons why a low P/E ratio doesn’t necessarily mean that the stock is a good value stock:

1. Investors are willing to pay more for a stock if they believe it will grow down the road.  Wondering what the P/E ratio is for Facebook (FB)?  It’s 119!  What about LinkedIN (LNKD) – it’s 679!!!  How about Twitter (TWTR) – they don’t even have earnings!!!!
2. Stocks from different sectors (industries) typically command different P/E ratios.  As you can see from the table above, the general P/E ratio for chip manufacturers is in the twenties.  The average P/E ratio for electrical power companies is generally much lower than this.  The average P/E ratio for telecommunication companies can be 40 or higher.
3. Earnings could be tanking and the price could be dropping off a cliff.  Research in Motion (BBRY) anyone???  The makers of Blackberry used to own the mobile smart phone arena.  When the iPhone and Droid came into town, RIMM’s marketshare began to plummet.  One look at their P/E ratio, and it would seem like the stock would be a great value right?  The P/E was low and going lower (now it’s undefined since they’re losing money).  Hmmm… it seems that no one wants to touch this company with a ten foot pole.  Just because the stock has a low P/E ratio, doesn’t make it a great deal!  The company also has to be at least maintaining things 🙂

Investment Tips – Don’t Mistake a Low P/E Ratio for a Value Stock – Final Thoughts

This article brought you up to speed on what the P/E ratio is and how it can be useful in helping you to identify the best stock to select from a particular industry.  Remember, the P/E ratio is just ONE tool to help you in your decision.  Using the P/E alone can be a recipe for disaster, as many times companies that are on the path to bankruptcy will have a low P/E.  Forbes’ get rich through investing advice of “don’t mistake a low P/E Ratio for a value stock” is a great investment tip that you should always keep in mind!