How do we figure this out when it comes to buying stocks? Shareholders don’t write reviews after buying shares but there is a way they indirectly tell us what they think of the value of the company – it’s the price-to-earnings ratio (or P/E). This is the ratio of the company’s share price to its earnings per share. In other words, it’s a way of comparing the ability of the company to earn money (certainly an important way of determining value) to how much people are willing to pay for a share. To calculate the P/E, we take the current stock price and divide by its earnings per share (or EPS). The P/E allows us to evaluate what people are willing to pay for one dollar of the company’s earnings. In the Telus example, the P/E is 15.4 which means you’re paying $15.40 for every dollar of earnings the company generates. We can think of the P/E as a way of asking “does the company make enough money to warrant the price of the stock?” A low P/E is like a product with lots of positive reviews – it’s good quality at a good price. A high P/E means the stock price could be out of whack with the earnings of the company and, eventually, people will realize that and the price will experience a correction – possibly a major one.
Sometimes share prices are affected by speculation on events which might happen in the company’s future. Maybe they’re releasing a hot new product that is expected to do well and their share price takes off as investors drive it up in anticipation. What if that hot new product turns out to be a dud? We want to avoid buying that stock at an inflated price and then suffering through the correction. Of course, lots of people have made lots of money speculating on future prices but we aren’t interested in risking our money. It`s easy to find headlines online like “5 Stocks Set to Double This Year” or “Stock Secrets Insiders Don’t Want You to Know.” Don’t be fooled – nobody can predict what a share price will do. We want to play it safe by making purchases to hold for the long term and then sleeping well at night. As with the other factors, I assign a score to each stock on the S&P 100 based on the P/E. Remember that a low P/E is good so high scores are awarded to stocks with low ratios.
My strategy makes it unlikely to get fooled by a temporary volatility in a stock price because I’ve already considered the 52 week high and low so we know how the price has behaved recently. Still, it is possible that a stock price was dramatically inflated sometime over the last year (thereby increasing the 52 week high) while being currently well below that (thereby seeming to be on sale) and still be overvalued (i.e., has a high P/E). There are lots of companies on the S&P 100 so why take a chance?
