When you want to invest in a stock, one big question is: Is it cheap or expensive? In the world of investing, one of the most popular tools to answer this is by using stock multiples. These multiples help you understand how much you are paying for a company’s earnings. In this article, we will look at how to use stock multiples, especially the P/E ratio, to decide if a stock is a bargain or too pricey. We will also talk about other multiples and key ideas like trailing P/E, forward P/E, valuation, and value trap. This guide is written in simple language so that everyone can learn how to judge cheap stocks and expensive stocks.
Introduction: The Idea of Stock Multiples:
The adage “buy low, sell high” is easy to remember but not always easy to understand. How do you know whether a stock’s price is low? That is where stock multiples come in. A stock multiple is a number that tells you how much you pay for a share of a company relative to a key financial measure, most often its earnings. This measure is known as the P/E ratio or price-to-earnings ratio.
Stock multiples enable investors to see if a stock is bought at the right price when compared with the actual earnings of the company. They’re similar to a price tag at the store. Just as you may compare how much meat costs per pound at a butcher shop, you can compare stock multiples to figure out if one stock is cheaper or more expensive than another.
What are Stock Multiples?
Stock multiples are ratios that compare a stock’s market price to a number that represents the company’s performance. The most common multiple is the P/E ratio. However, there are many types of multiples, including:
- EV/EBITDA (Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation, and Amortization)
- Price-to-Book ratio
- Price-to-Sales ratio
Each multiple tells you something about the company. In this article, we will focus on the P/E ratio because it is the easiest to understand and the most popular.
The P/E Ratio: What Does It Mean?
The P/E ratio, or price-to-earnings ratio, is one of the simplest stock multiples. It tells you how much you are paying for one dollar of a company’s earnings. The formula is simple:
- P/E Ratio = (Stock Price) ÷ (Earnings Per Share)
For instance, assume a company called Plain Bagel Co. If the price of each share is $30 and the company earns $2 per share, then the P/E ratio is 15. This means you pay 15 times the earnings per share to buy a piece of the company.
In simple words, the P/E ratio calculates how many dollars an investor needs to spend to purchase one dollar for which the company earns. An extremely high P/E ratio most of the time means that people are willing to pay more dollars for every single dollar of earnings. However, a low P/E ratio often suggests that you are getting an undervalued stock. However, you don’t just base your call using a number.
Trailing P/E vs. Forward P/E:
There are two ways to look at the P/E ratio:
Trailing P/E:
- Trailing P/E is calculated using the company’s past earnings.
- It is based on historical data.
- This ratio tells you what investors paid in the past for each dollar of profit.
For instance, if Plain Bagel Co. had earnings of $2 per share last year and the stock price is $30, then the trailing P/E is 15. It is like looking at a receipt from last year.
Forward P/E:
- Forward P/E is based on what the company is expected to earn in the future.
- It uses forecasts or predictions.
- This ratio helps investors understand what they might pay for future profits.
For instance, if Plain Bagel Co. is earning $2.5 per share next year and the price of the stock has remained at $30, then the forward P/E is 12. This lower number may make the stock seem like a better deal if you believe the company will grow.
Both metrics are useful. Trailing P/E reflects past performance, whereas forward P/E reflects the future. Investors make use of both to gain a clearer view of a stock’s valuation.
How to Calculate the P/E Ratio:
Let’s break it down with an easy example:
- Find the Stock Price: Let’s assume that the price of one share is $30.
- Determine the Earnings Per Share (EPS): If a company makes $2 per share in profit, then:
- Calculate: $30 ÷ $2 = 15.
This means that the P/E ratio is 15, so you pay 15 times what the company made in earnings per share.
It’s a useful stock multiple that you can also compare over time or with others.
Comparing P/E Ratios Over Time:
A one-time P/E ratio does not give you an accurate picture of what is going on. You need to compare it with:
- The previous P/E ratios of the company (its history average).
- The P/E ratio of other companies in the same industry
Comparison across the History:
If Plain Bagel Co. has a P/E ratio of 15 most of the time but now its P/E ratio is 12, it may seem cheaper than usual. This can be a buying opportunity if everything else is sound. But if the fall in the P/E ratio is due to the earnings of the company expected to drop, then there is trouble written all over.
Peer Comparison:
Suppose you compare Plain Bagel Co. with other companies like Sesame Sands and Hangul Bagel. If Sesame Sands has a P/E ratio of 13 Hangul Bagel’s P/E ratio is 7, and Plain Bagel Co.’s forward P/E is 12, you might say Plain Bagel Co. is more expensive than Hangul Bagel but cheaper than Sesame Sands. However, the real value depends on the quality of the company’s business, its fundamentals, and its growth potential.
Using Multiples to Identify Cheap Stocks and Expensive Stocks:
The basic premise of stock multiples is to give you an idea of whether you are paying too much or too little for a company. A few key takeaways:
Low Multiples:
- Could be an indication of a cheap stock.
- But a low multiple can also mean the company has problems.
- Always check the company’s fundamentals.
High Multiples:
- Generally, it is an indication of an expensive stock.
- However, if a company is growing fast, a high multiple might be justified.
- Growth companies, especially in tech, often have higher P/E ratios.
Relative Comparisons:
- Compare the P/E ratio to the company’s history.
- Compare it with competitors in the same industry.
- This comparison is like checking the price per pound when shopping for meat.
- Even if one steak is cheaper per pound, it might be of lower quality.
Value Traps:
- A stock that appears cheap may be a value trap if the company’s business is weak.
- Always look at the overall health and future prospects of the company.
Warren Buffett is an investor, and the most popular saying by him goes as follows: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” So, if a stock has a very low multiple, then it’s not a good buy if the company is weak.
Limitation of Multiples:
While stock multiples are very useful, they are not the whole story. Here are some things to keep in mind:
Historical Data vs. Future Expectations:
- Trailing P/E looks at past earnings, but the market is forward-looking.
- Forward P/E relies on estimates, and those numbers can change.
Different Industries:
- Some industries naturally have higher or lower multiples.
- For example, tech companies often have high P/E ratios because they grow fast, while utility companies usually have low P/E ratios.
Management and Accounting:
- The numbers in the P/E ratio come from the company’s financial reports.
- Sometimes these numbers can be changed by how the company reports its earnings.
Not a Standalone Tool:
- A multiple should be used with other analyses.
- It is a rough gauge and needs context from the company’s overall performance and market conditions.
Multiples are a quick way to get a sense of a stock’s valuation. However, they should not be the only tool you use when making an investment decision.
Other Multiples in Stock Valuation:
Apart from the P/E ratio, many other stock multiples can help you judge whether a stock is cheap or expensive:
EV/EBITDA:
This multiple compares the company’s total value (enterprise value) to its earnings before interest, taxes, depreciation, and amortization. It is often used for companies with high debt levels.
Price-to-Book Ratio:
This shows how much you pay for the company’s net assets. It is useful for companies with a lot of physical assets.
Price-to-Sales Ratio:
This compares the company’s stock price to its revenues. It is used when a company is not yet profitable.
Of course, every multiple has its strengths and applies better to some industries than others. For most investors, the P/E ratio makes a nice introduction because of its ease.
A Step-by-Step Guide to Using Multiples:
Let’s go through a simple process to decide if a stock is cheap or expensive using stock multiples:
1. Get the Numbers:
- Find the stock’s current price.
- Look up the company’s earnings per share (EPS).
2. Calculate the P/E Ratio:
- Use the formula “Stock Price ÷ EPS.
- Example of Plain Bagel Co.: stock price is $30, EPS is $2. P/E ratio is 15.
3. Check Historical Multiples:
- Compare the current P/E ratio with its historical average.
- A multiple lower than usual might suggest a bargain-but only if the company is healthy.
4. Compare With Peers:
- Scan similar companies in the same industry.
- If Plain Bagel Co. has a P/E ratio of 12 while its competitors have 10, it may be pricier than its peers.
5. Look at Forward P/E:
- See what analysts expect for future earnings.
- A lower forward P/E might indicate future growth and a better price.
6. Examine the Company’s Fundamentals:
- Read about the company’s performance, news, and future prospects.
- Make sure that a low multiple is not due to problems with the business.
Be Wary of Value Traps:
- A stock may appear cheap just because the multiple is low, but if the outlook about the company is terrible, it may trap you.
- Always check the quality of the business.
The above steps can help you determine whether a stock is a good buy. No single number will tell the whole story. Use multiples as one part of your overall valuation process.
The Big Picture: Multiples Integration with Other Tools:
Stock multiples, such as the P/E ratio, are a quick snapshot of the stock price. Intelligent investing always has to look at the big picture:
1. Market Trends:
The general market and economy can influence stock prices.
2. Industry Conditions:
All industries have norms. Compare the stocks only against their peers within the same industry.
3. Company News:
New products, a change in leadership, or an expansion plan can influence the future earnings of a stock.
4. Growth Potential:
See how fast a company is growing. A high P/E ratio can be acceptable for a company that has a bright future growth.
By integrating stock multiples with other factors, you get a full view of the real value of the company. This will make sure that you do not fall into a mistake, like buying a stock that has a cheap appearance but weak fundamentals.
Real-World Example: Plain Bagel Co.
Let’s take a very simple example and see how multiples work in the real world. So Plain Bagel Co. has:
- The current stock price of $30.
- Earnings per share last year was $2, which means its trailing P/E is 15.
- It’s expected to make $2.5 earnings per share next year, so that makes a forward P/E of 12.
Now suppose you look at two other companies also.
- Sesame Sands has a P/E ratio of 13.
- Hangul Bagel, P/E of 7.
Here, you can find that Plain Bagel Co. is trading at 12 times its expected earnings. If competitors have lower multiples, then Plain Bagel would be a little pricey relative to them. On the other hand, if Plain Bagel is growing faster or has better prospects, the multiple might be justifiable.
But with these numbers alone, you make use of this as a takeoff point; they help determine if the existing price of stock makes sense about its past trend and what’s happening in terms of other equities. From this process alone, you determine whether a given stock is actually a good investment.
Pitfalls: Why Low Multiples Are Not Cheap:
Remember that a low multiple does not always mean the stock is a good deal. At times, a low P/E ratio may serve as a warning sign. That situation is often referred to as a value trap. Here’s why:
1. Poor Fundamentals:
If it’s true that a company is earning less money because of severe problems, then the P/E ratio might be low for a good reason.
2. Decline in industry:
If the whole industry is shrinking, even a low multiple might not save the company.
3. Temporary Issues:
Sometimes, a stock may drop temporarily due to bad news, but if the company is strong, the multiple will rise again.
Always check the company’s fundamentals, its overall business health, market position, and growth prospects, before deciding to buy a stock that looks cheap.
Final Thoughts: Making Smart Investment Decisions:
Using stock multiples will be smart for sorting out whether a stock is cheap or expensive. The P/E ratio is a handy tool that gives you a quick look at how much you pay for each dollar of earnings. This method is useful in understanding whether the stock price is right, compared over time and against other companies.
But remember, numbers alone don’t tell the whole story. Look at the company’s fundamentals, market trends, and growth potential. Multiples are a starting point in your investment research. They are best used as part of a broader approach that considers many factors.
As Warren Buffett has wisely said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” In other words, you should focus not only on finding stocks with low multiples but also on finding companies with solid fundamentals that will grow over time. When you do this, you are likely to make more prudent investment decisions.
Conclusion:
Stock multiples such as the P/E ratio are a quick way to gauge if a stock is cheap or expensive. They show how much you pay for each dollar of earnings and help compare stocks over time and against peers. However, they must be used with care. Always check a company’s fundamentals and growth potential to avoid value traps. By using a balanced approach, you can make smarter investment choices.
FAQs:
1. What are stock multiples?
They are ratios that compare a stock’s price to a key number, like earnings.
2. How is the P/E ratio calculated?
Divide the stock price by the earnings per share.
3. What is trailing P/E?
It uses past earnings to calculate the ratio.
4. What is forward P/E?
It uses expected future earnings for the calculation.
5. Can low P/E ratios be a trap?
Yes, they can indicate weak fundamentals.
6. Should I only use multiples to invest?
No, also check the company’s fundamentals and market trends.