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Sunday, April 14, 2013

P/E Ratio Explanation

Well, it's been a month since I last posted. I feel extremely bad about it, so in my opinion if you still want to read then you should have a good explanation about what a P/E ratio really is in my book.

To keep me posting, I will be starting...

I know it's cheesy, but it's mostly a way I can make sure that I stay consistent on this series I have created.

In my understanding, a P/E ratio is a valuation, to the simplest degree regarding a company compared to it's share price.

The formula is:

But really, you don't have to end up calculating it yourself. This is such a commonly used fundamental ratio for the valuation of stocks that you don't need to even worry about pulling out a calculator and doing this. Any financial website is bound to have a P/E Ratio about the share shown.

What I aim to do is to help you understand what it really means. 

We have to understand that the P/E Ratio is what it is because it is just how much of a multiple investors are willing to pay for the earnings per share of the stock. 

Some investors may be willing to pay a higher multiple for the earnings of a stock, which results in a higher P/E ratio, but why? Why should they be willing to pay, in a sense, extra?

We have to realize that investing is for the future, not for the present. 

People want to pay out higher P/E ratios than the average (compared to the S&P 500, Dow Sector Indexes, or S&P Sector ETFs for stocks in that sector) because they believe that the company's growth or future prospects is going to better than that average.

We can take a real life example for this:

LNKD (LinkedIn) P/E: 965.57
GOOG (Google) P/E: 24.33
AOL (AOL) P/E: 3.56

Internet Information Providers - Avg P/E: 25.40

We can see that investors believe that LinkedIn has a much higher P/E Ratio than average, which could either symbolize an overvaluation (if the investor decides so) or just hopes for better fortunes later on. 

What you should always remember is that although the P/E ratio of LNKD is much higher than the average for the Internet Information Providers, it is not necessarily overvalued.

Also, even though AOL's P/E ratio is much lower than the average P/E Ratio for the industry, it is not necessarily undervalued. Even Google may be over or undervalued depending on what the investor sees it's future fortunes as.

LNKD could just be a much better company, and or have higher estimated earnings later on (which is reflected by the Forward P/E Ratio)  and AOL could be a worse company, and or have lower estimated earnings for the next fiscal year.

The management for both companies can also be very different, LNKD's management could be outstanding, while AOL's management may be so-so. There is proof that AOL has failed many times before with previous flops such as the acquisition of Time Warner not bailing the failing company out of trouble. (Or so I've heard).

It could also be the fact that AOL has been around for a long time, while LinkedIn is a relatively new company. Most older companies get lower P/E ratios as investors normally think the growth has been all used up, and vice versa.

The thing is, there is no true way to tell if a company is over or under valued. You have to trust your own intuition, judgement, and understanding of companies.

For example: in theory, AOL is undervalued, and LNKD is overvalued, but even so, although the price of LNKD may seem too high, the general public may not see it and LNKD's price over 1 year may have a better performance than AOL's, as people may sell shares of AOL and move on to other companies. AOL could have an even lower price one year later and therefore become even more undervalued, so it is up to the investor to decide which of the two to pick, and when to enter.

Adding on with the fact that there are also other metrics an investor has to take into account before choosing a stock, valuation of stocks can be a very intricate and tiring process.

But if you even just look at the P/E ratio, then you already have an upper hand over the masses of amateur investors that don't even care about this very important metric. It is vital that you know what this means and how it can affect your investment decision.

If you get it right, or find a good understanding of how the P/E ratio works at different times and in different industries, you will have an invaluable advantage over other investors regarding stock picking.

I will be back some time explaining more metrics.

Portfolio Update:

The portfolio is doing absolutely marvelous. I am really proud of it, and the progress it has been making.

Well, the main account with my stocks: REGI, BBSI, HD, RGA, and SYNT have done super well. (I can't tell you the actual proportions of it).

I recently actually was faling behind the DOW but I recently caught up with it in my performance.

I have had 16% return so far in these 3 months so far, which is great!

I really love this GIF.

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