Monday, 1 August 2016

Investment metrics : P/E Ratio

Another conversation happened recently.  "Peter, how do you know which stocks to pick?"  Well I will never advocate that I can pick winners every time.  But to at least know the basics of how to pick and what to look for as a "retail investor".  Since this term has been given to us by the real investors, aka the fund managers.  When a fund has a bad day, nothing really happens, they lose money and the fund manager continues with his life.  If a retail investor has a bad day, it can change your lifestyle if you are not careful.  That being said, to be careful, I use certain investment metrics to help me pick a stock.  This blog post will examine the investment metric called P/E ratio.

The P/E ratio or price-to-earnings ratio is likely one of the best known fundamental ratios, it's also one of the most valuable.  The P/E ratio divides a stock's share price by its earnings per share to come up with a value that represents  how much investors are willing to shell out for each dollar of a company's earnings.

P/E ratio

In the chart above, which is simply the big 6 banks in Canada currently and what their stock price is on August 1, 2016 along with their P/E ratio.  Why I am only using the same stocks in the same industry.  The reason being you can only compare P/E ratios of a similar company, that is where it is most valuable.  You could say it is comparing apples to apples and oranges to oranges.  I would not compare say a bank P/E ratio to a food stock P/E ratio.

So someone asks me which stock to buy that is the best bank.  Most investors have their tickers loaded into yahoo finance or google or even directly on their smart phone.  They right away say either TD bank or National bank.  TD trades at $56.89 and National trades at $44.71 so they are the cheaper stock, right?  That would be incorrect using technical analysis which includes looking at the P/E ratios.  I would answer that CIBC is the cheapest stock right now.  They answer, how can that be?  CIBC is at $99.19 which is almost double TD bank?

The answer lies in the P/E ratio.  CIBC's is at 10.88 vs TD Bank at 12.96  Simply put, investors value TD more than they value CIBC.  "Buy low, sell high".  Remember that old saying.  Using the P/E ratio, you buy lower valued stocks to sell high later.

Looking again at the chart, you will notice that BMO's P/E ratio is higher than the other banks by quite a bit.  Double CIBC's in fact.  This right away tells me that investors have rallied BMO stocks more than other bank stocks.  They think BMO will perform better than the other banks.  If you were to buy bank stocks today, I would take a double take at BMO and maybe avoid buying them using the P/E ratio as your guide.

At some point, you will come to the point of investing money into the bank stocks.  How much money tho?  $1,000? or $5,000?  Let's assume you are going to buy $5,000 worth of bank stock.  For BMO, that would be 58 shares, for TD that would be 87 shares and CIBC that would be 50 shares.  So basically you are buying $5,000 worth of stock but CIBC at $99.19 seems expensive?  It's the same amount of dollars invested, don't assume the stock price determines who is cheap and who is not?

Now you have a general understanding of using P/E ratio analysis to help you determine whether a stock is a buy or no buy.