Is learning more about investments, or starting a more intelligently planned portfolio of your own, among your 2018 New Year’s resolutions? This is true for many Canadians, and it’s important for new investors to understand some of the core concepts that will help them make the best decisions and manage their money effectively.
As always, your humble blogger reminds you that we at Progressa are not financial advisors by trade, and that it’s a great idea to seek out a professional advisor to help you answer complex and specific questions. That being said, let’s dive in to one of the most fundamental metrics most investors will use to gauge whether a stock might be suitable for their investment portfolio: price-to-earnings, or P/E ratio.
As Investopedia defines it:
“The price-to-earnings ratio, or P/E is the ratio of the market price of a company’s stock to its earnings per share (EPS).”
For example, if a company’s shares are trading at $20 and it’s earnings per share was $1.25 over the past year, the trailing P/E for that year would be 16:1. Effectively, this tells you that the price for $1 of earnings is $16, as a quick shorthand. And of course, any company that is not making a profit will have their ratio listed as “N/A” or not applicable as they lack any earnings!
If you flip this ratio around, you find out the earnings yield potential of the firm – namely, how much return a theoretical investment of $1 would yield. Earnings yield is another exceptionally useful benchmark when comparing firms’ performance.
Why do we look at P/E ratios? For starters, they give us a way to make apples to apples price comparisons between the share prices of companies within similar industries – with the caveat, of course, that there are many other considerations to make as well. However, as a general barometer, the lower the ratio is, the more attractive a stock may be when it comes time to add to one’s portfolio.
With this in mind, a stock with a high P/E ratio may be a clue that investors in that company are anticipating higher growth to come in the future. This could also influence your decision to invest in that company. This is the point at which more detailed research is required, as well as an assessment of the amount of risk you are willing to tolerate as an investor!
The economist and investment strategist Benjamin Graham, who defined many of the core concepts of investment finance in the mid-20th century, once stated that one was likely to experience severe losses if a chosen investment fit the following criteria:
P/E Ratio < Earnings Yield + Growth Rate. If these conditions are satisfied, the firm’s stock is likely to be priced fairly or attractively given its potential for growth. Graham’s approximation eliminates a whole lot of potential candidates at first glance, but it is designed to do so! It’s a solid napkin math type of check to see whether or not an investment may have an acceptable rate of return, once again influenced by a huge host of external factors, but at the very least a signpost on the way to understanding the quality of an investment better before you commit to it.