Investing

Understand this important factor and become a successful investor!

By Kanwal Sarai
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Actually there are a number of important factors, 12 to be exact. I call them the 12 Rules of Simply Investing and I cover them in great detail in my online Simply Investing course. Today I am going to describe one of the 12 important factors the P/E Ratio. Understand this ratio, and you will save yourself from making poor investment decisions and save thousands of dollars in the process.

Before I knew what the P/E Ratio was all about, I did indeed waste thousands of dollars on lousy investments. I hope to save you from making the same mistakes I did.

The P/E Ratio is the Price to Earnings Ratio, which is simply this:

Stock Price divided by the Earnings per Share

or, for those that prefer formulas:

Stock Price / Earnings per Share

Let’s take a look at a real-life example, McDonald’s (Stock Symbol: MCD). Everyone knows about McDonald’s; they run a chain of 32, 748 fast food restaurants in 117 countries. They are pretty big and well know so I’ll use them as an example. (Full disclosure: As of this writing I do not own any shares in MCD. This is not a recommend for or against buying shares in MCD.)

Let’s take a look at the two numbers then as of today:

McDonald’s Share Price: $74.44
McDonald’s Earnings per Share (EPS): $4.58

Therefore the P/E Ratio is:
$74.44 / $4.58 = 16.25

This means if you were to buy the shares today you would pay 16.25 times what the company earned per share. Assuming all things being equal and the share price drops to $22.00 what happens to the P/E Ratio?

$29.00 / $4.58 = 6.33

Then you would be paying 6.33 times what the company earned per share. All things considered equal is it better to buy the shares at $74.44 or $29.00? It would be better to buy the shares at $29.00 because they would be cheaper, and you could purchase more for the same investment. Remember the saying “buy low, sell high”? You want to be able to buy low.

How does the P/E Ratio help you make better investment decisions? Let’s say you are considering buying shares in 3 companies, all 3 companies are in the same industry, they have similar numbers (dividend yield, debt, earning projections, revenue…) and the P/E Ratios are:

Company A: 49.65
Company B: 12.05
Company C: 189.43

Assuming all things being equal, Company B would be a better buy. I generally look for companies with a low P/E Ratio of 20 or below. There are some exceptions, but this rule has served me well for more than a decade.

It would be crazy to buy shares in Company C when the P/E Ratio is 189.43! But I remember during the high-tech boom in 1998-1999 so called “experts” and “analysts” were going on television recommending people to buy stocks in companies that had P/E Ratios of over 100, and 200!! They were saying “these are great investments, the shares will continue to rise, and the company has extraordinary growth potential!” Well we all know how that ended, when the technology bubble burst the following year.

 

This is why it is important to focus on the fundamentals, because the fundamentals don’t change very often. Forget the media hype and the latest investment fads and focus on what’s really important and you will be a successful investor!
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Kanwal Sarai

With more than 27 years of investing experience and a passion for investing and teaching, I demystify the world of investing. My goal is to help you grow your net worth by investing in quality dividend paying stocks. Build your own stream of increasing income today.

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