There are several ways to valuate and buy stocks. And yet most of us go about buying stocks in the worst way possible - we look at what other people are paying and pay no attention to the "fundamentals" of the company.
The value of a stock should be related to the underlying soundness of the company and what assets the company has, as well as its potential profitability. If a company has a share price of $10 a share and pays an annual dividend of 50 cents, that is not a bad return on your money - 5% in dividends (income) - even if the share price remains flat. And since you get that money back in cash, you aren't relying on nebulous things, such as the future value of the stock, to make your money.
Other companies pay no dividends, but have profits, which they either retain, or plow back into more R&D for the company or into buying other companies or investing elsewhere. To me, these are a little more nebulous, as you get nothing back directly for your stock purchase, other than the idea that the company is "worth more" and thus your stock might be worth more.
And yet, there are other companies whose share price goes through the roof, even though they have little or no assets, pay no dividends, and don't even show much in the way of profits - or any profits - or in fact incur losses. People pay a lot for these stocks based on the idea that "some day" they might be worth a lot of money - to someone else. But it is like buying condos in Florida in 2005. You always have to hope there is a "bigger fool" (motley or otherwise) who will pay more for the unit that you already overpaid for.
Many analysts dismiss people who "crunch the numbers" on a company as being number-based and thus missing the larger picture.
But the other way to buy stocks is much riskier. And most financial pages, websites, and TeeVee shows tout this latter technique. To their mind, the only thing that matters is the stock price - what others think the company is worth. And they even go beyond this, looking at the change in stock price over time (the first derivative, if you took Calculus) and buy and sell "options" on the future price of the stock. This is little more than gambling, of course, not investing.
The Price to Earnings Ratio (P/E) is one number that "numbers crunchers" use to figure out if the stock is worth anything. And P/E ratio is anything but transparent.
Taking our first example above, if the company makes 50 cents a share in profit and the price of the stock is 10 dollars, then the P/E ratio is 20 - the stock is 20 times as much as the profit per share. Some folks look at this as the number of years you'd have to hold the stock to make back your investment - which is a sound way of looking at things. In other words, in 20 years, if the company keeps paying out 50 cents in dividends, you'll make back your $10 investment in the stock.
But note that the P/E ratio is based on profits, not dividends, which are two different things. A company may make $1 a share in profits, but pay out only 50 cents in dividends, retaining the rest as retained earnings or using it to buy another company, invest in a new product, or whatever. So you may not really be "earning" that money back.
A second number, the Price/Dividend ratio, is, as you might think, based on the price of the stock divided by the dividends paid. Again, using our first example, the P/D ratio would be 20, if dividends were 50 cents a share and the share price was 10 dollars.
And 20 would be a pretty stellar P/D or P/E ratio these days. Many folks like to look for a P/E ratio in the 20's as a sign of a good investment. But others are willing to go much higher or even to negative numbers.
For example, as I noted before, Zipcar recently did an IPO where the share price doubled, even though the company has yet to make a profit. Calculating the P/E ratio here is hard to do, as the profits are negative, so you end up with a negative number. The earnings per share in Zipcar are -$1.17, which at a share price of $26 means a negative P/E ratio. People are betting the company will do better in the future, make wild profits to wipe out its debts and return equity to investors. Or, they hope some greater fool than they will pay even more for a money-losing company.
LinkedIn did an IPO recently and while the company is making money, people quickly bid up the stock, on the premise that anything relating to Social Networking is "hot". The P/E ratio has varied from 680 to 980, which means you'd have to hold that stock for 680-980 years to get your money back, not even taking into account inflation. Some might say this is a radical over-valuation of a company.
And I would be one of those people. While Social Networking is an interesting phenomenon, it is also an interesting fad, and many people are tiring of it already. And the more it becomes a way of marketing to people, I think the more it will be a turn-off to folks. People do not like being lead around by the nose, as evidenced by the regular outrages over privacy concerns relating to these Social Networking sites.
So while these sites may be profitable, I doubt they will be 100 or 1000 times more profitable in the near future - enough to justify a P/E ratio in the 600-900 range. People are just overpaying for stocks, just as they overpaid for houses five years ago - convinced that "some greater fool" would pay more, and if they didn't buy now, they would be "priced out of the market forever!"
And the tech stock people would argue that P/E ratios are not relevant for new industries. Everyone in that sector hopes to be buying the next Microsoft or Apple or whatever, and that the stock will go up, up, up, as the company takes off and dominates the industry. But of course, picking the winners in losers in tech can be a crapshoot. Often you are betting on formats (Blu-Ray versus HDTV) only to be blindsided by other options (downloading content on the Internet).
Old line companies that have a steady business selling products with known profit margins, have much more rational P/E ratios. The trailing P/E ratio for Archer Daniels Midland company - the corn people - is about 9.71 with a dividend yield of over 2%. ExxonMobil has a similar P/E ratio of 11.59 and a dividend yield of 2.3%. Wal-Mart clocks in with a P/E ratio of 12.85 and a dividend yield of 2.64%.
Old line companies in traditional marginal businesses have fairly low P/E ratios and high dividend rates. They are not sexy companies with wild fluctuations in share price (get rich quick schemes) but are instead regularly profitable and crank out dividends on a regular basis.
By the way, if you look at ExxonMobil's numbers you may wonder what the fuss is about in Congress. While the company is making "record profits" it also has record expenses, and a 2.3% dividend rate is hardly anything to write home about. But of course, stock price varies based on earnings, and here, the stock price of ExxonMobil has gone up in recent years as profits have. Nevertheless, it would not appear from the P/E ratio that investors think that XOM is going to make even more money in the future.
Some analysts note that in looking at P/E ratios, you should look at comparable P/E ratios for the same industry. For example, Southwest Airlines has a P/E ratio of 20.25 which sounds bad compared to that of ExxonMobil, but is stellar compared to United Air Lines (UAL) P/E ratio of 531 (!) which makes LinkedIn look like a freaking bargain.
But the valuation of P/E ratio might be based on other "fundamentals" besides earnings. For example, the airline owns a lot of planes and gate spaces, etc. which are worth a lot of money. So a company that has little or no earnings but has a high liquidation value might have a very high P/E ratio as well. But on the other hand, one would have thought GM had a lot of inherent value as well, and then the government stepped in and told the shareholders otherwise.
While a company that has a low P/E ratio might be seen as a good bargain, there is a downside to low P/E numbers as well. A company with a low P/E ratio might merely have a low share price. And this could be because the stock is undervalued, or that the market thinks the company is going to go bankrupt in short order. For example, a company that is losing market share and seeing lower and lower profits may still have a low P/E ratio, making it appear to be a bargain. But the profits will keep going lower, until they go negative, and the company faces bankruptcy. So before you jump on a stock with a low P/E ratio, make sure the company doesn't have one foot in the grave!
My personal portfolio is fairly conservative - limited to companies that have fairly low P/E ratios and which usually pay dividends. These do not make the radical spikes in prices that some stocks make, but they don't crash as hard, either. Most stocks I have bought which are speculative have spectacularly failed. It turns out that it was I who was the "greater fool" who bought the stock for a higher price, and the resultant fool shortage thereafter meant that I lost money.
Greed and Fear drive the market, and oftentimes we worry that we are "missing the boat" on great investments. For example, Netflix was a good buy - a year ago - when it went from $50 a share in 2010 to over $250 today. People saw the online movie distribution model and said "this is the next big thing" - and they are probably right. But even then, the P/E is a relatively modest 70.57 (modest compared to Zipcar or LinkedIn). The problem is, it is too late to buy Netflix, and one could argue that the stock for this company - whose business is pretty basic - is already overvalued.
And since Netflix is now the Number One user of Internet Bandwidth, some growing pains are sure to follow. Already, AT&T is talking about charging for bandwidth usage - so that chronic Netflix viewers will have to pay extra for viewing more movies. No doubt the Cable companies will be next on this bandwagon, as they see more customers unplug from cable and plug into Netflix (as I did). This could spell trouble for the growing company.
But that is the nature of these high P/E stocks - they are speculative in nature, and sometimes unforeseen things occur that blow a stock right out of the water. Like the river of sand, I recently wrote about, sometimes you can't see what can happen nearly overnight, when your waterfront property turns to beach property as an entire river turns into a sand bank.
In the past, my investments in stocks have been pretty poorly planned. Like most folks, I was looking for the next "insider tip" for the "next big thing" and was betting on technologies, not thinking about fundamentals. Most of my investments were in Mutual Funds, where I had no idea what I was investing in. But when I bought stocks, I either locked onto a brand name I had heard about (usually companies that produce consumer goods) or a company that was making headlines due to its gains in share price.
Both are probably bad ways to invest in stocks. As I am getting older, I realize I can't afford to gamble on "the next big thing" anymore, and instead should concentrate on more sedate and secure investments - and this means stocks with lower P/E ratios.
As I noted recently, I don't think we are in for a huge market "crash" this year. However, I do think we are heading for a second "tech bubble" as more and more of these money-losing or marginal website-based companies do IPOs which go into the stratosphere, based on little more than euphoria and wishful thinking. And not looking at P/E ratios is part of the problem with those stocks.