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How to Invest in Stocks The PE Ratio

How to Invest in Stocks The PE Ratio
How to Invest in Stocks The PE Ratio

How to Invest in Stocks The PE Ratio hello and welcome to sovereign financials financial education for everyone all right guys so today is going to be the first part in a series of how to invest in stocks and today were specifically going to be looking at the pe ratio using the pe ratio is one of the best ways to start binding value stocks the idea behind value investing is making investments in companies where the price of the stock is less than or equal to the value of the stock value investing is how people like Warren Buffett and Charlie Munger have made billions of dollars now you might ask what is the difference between price which is also called cost and value the difference is quite significant however most average investors do not know what the terms mean cost is the price of an individual stock this is the price that is listed on your favorite news channel or on websites such as Morningstar com market watch calm or Google Finance now finding the price of a stock is quite easy however determining the value of a stock is a very different story now I use a much more complex idea value means what the stock is actually worth and youre not gonna find this number published anywhere as value can be calculated in many different ways and the results are gonna be different between different investors a stocks price and its value can be very different and when the stock costs less than its value which means that it costs less than what its actually worth that would be a good investment for the value investor all right so lets start with an example thatll be more familiar to most people in the first example this house here is priced at five hundred thousand dollars and has two thousand square feet now all the other houses in the area that also have two thousand square feet are priced at two hundred and fifty thousand dollars and theres no other significant difference between the different houses that would mean that this house priced at five hundred thousand dollars cost more than the value of the home since we can obtain an equal house for two hundred and fifty thousand dollars in the same area this means the price of the house we want to purchase is greater than the value of the house and we should not purchase it it would therefore be a bad investment the exact opposite could be true if this house now cost a hundred thousand dollars while all of the other equal houses in the area cost two hundred and fifty thousand dollars this would mean that the price is now less than the value of the home and it would be a great value investment now price and value differ when the stock market has become emotional or a characteristic of the company has gone unnoticed by the majority in our first example here we have an average price market where the price people are willing to pay for an asset is equivalent to the value of the asset our second example is called an overpriced market sometimes well people will call this an overvalued market but dont let their change in words confuse you this in this situation the asset is overpriced compared to the value of the investment they are making this happens when people get very excited about a company and they think it will make much more money in the future than they are currently making and oftentimes theyve become too optimistic in their estimations our third example here is an under priced market also sometimes called an undervalued market but the meaning is exactly the same in this situation people believe the company will perform much worse in the future than how its currently doing these people are usually over pessimistic now a good investor will have a way to determine what the investment is actually worth which is known as its value and then compare the current price of that invest to the value that we calculated and then we can determine if it is fairly priced or if its over price or if its under priced and this will help us to determine if its a good investment for us or not in this specific lecture well be going over the pe ratio to determine the value of various stock investments now let me ask you a question if you owned a company in a lost money every single month and never makes any profit what would the value of the company be the answer to that question is zero dollars or technically a negative number since it takes money out of your pocket every single month on the flip side if you owned a company and that company made ten thousand dollars a month what would the value of that company be this is a much more difficult question but at least you know that it has to be a positive number since it makes you money every month well work on figuring out how to assign value to this income which is called earnings when its made by a business okay so lets start by defining a few terms the first term is earnings earnings is the profit that a company made and its usually spoken about in regards to the money they made in the entire past 12 months however it is reported on a quarterly basis and this part will be discussing earnings in regards to how much money they made over the entire past twelve months this is essentially a measure of how profitable the company was in the past one year now stocks are shares of a company and by owning shares of a company youre a partial owner of the company specifically a partial owner of their profits lets take this grocery store for example here it has four shares and lets say their earnings over the past 12 months was 4 that means if you take those 4 you divide it by the total number of shares which is 4 their earnings per share of stock is 1 now lets get on to the pe ratio using the stock from our previous example the company made a total of 4 in the past 12 months and it had a total of 4 shares of stock giving us an earnings per share of 1 this earnings per share of 1 is the basis for value of this company now if we look at the price of the stock on the market by going to marketwatch.com or Morningstar com lets say it costs 10 per share since the pe ratio is the price to earnings ratio we will then take the price of 10 and divide it by the earnings per share which is 1 so 10 divided by 1 gives us a pe ratio of 10 so what is a fair pe ratio according to Warren Buffett and Benjamin Graham who wrote the book the Intelligent Investor and taught Warren Buffett how to be a good investor a pe ratio of less than 10 would be considered to be under priced and would make for a good value investment now a pe ratio of 15 thats a fairly priced stock and is still a good purchase for a value investor however when you start getting to pe ratios of 20 or more that starts falling into the over price range and a value investor would not typically buy these kind of stocks and last but not least a pe ratio of greater than 30 indicates its an extreme bubble and it would probably not be a good idea to invest in that type of stock all right so lets take a realworld example of what this might look like were gonna go to market watch calm as you can see up here at the top of the bar and were gonna look at a couple stocks so the first stock were gonna look at is going to be Amazon so were gonna click on Amazon down here and whats nice about websites like market watch or a Morningstar or even Google Finance is you dont have to do any of these calculations yourself the websites already put them together for you so if you can see right down here this one here says earnings per share lets zoom in on this a little bit make this a little bit easier to see so this says earnings per share right here and its twelve dollars and sixty cents now the price of an Amazon of one share of Amazon stock is two thousand dollars so the way I want you to look at is this is your pain 2, 000 2, 000 for a claim on earnings per share of 12.60 so youre paying two thousand dollars to have a right to 12.60 of their earnings whats nice is already calculates a pe ratio for you which is a hundred and fifty five now these can vary a little bit you would just take the price of the stock divide it by the earnings per share and you should get the pe ratio however these PD ratios are calculated on a quarterly basis so these things dont always match up perfectly but they come pretty close so a pe ratio 155 according to Warren Buffett who learned from Benjamin Graham would be considered to be an excessive bubble there are a couple reasons why Amazon stock is as high is because people think itll take over the world in which case if it does take over the world people are assuming that the earnings per share would go up and this the price of stock when I go up is not as much and therefore the pe ratio would come down upon quote quote taking over the entire world with that being said thered be its kind of like a gamble or some speculation because as Amazon gets too big thered be a lot of monopoly laws and antitrust laws that come in place but this is 155 is people being over optimistic so this Amazon in my opinion right now would be overpriced as youre paying 2, 000 for just a claim on 12 bucks all right lets take a look at another stock lets look at lets look at Apple right Apple has a pretty big market share lots of people end up using Apple phones the Mac computers etc so Apple has the earnings per share of 11 which is pretty close to Amazon so per share Amazon and Apple are almost making they almost make an exact same amount of money per share out there now if you look at what the Apple stock cost is two hundred and twenty six dollars I mean that youre paying two hundred and twenty six dollars for a claim on eleven dollars right and that gives you a pe ratio of twenty point two three the two point two three does really matter too much because your P ratio 20 so this is much for how much earnings per share youre getting this pe ratio is a much better deal so they both have large market shares apples potentially getting bigger Amazon might get bigger but in terms of how much youre having to pay the price 226 for the value which is the earnings per share Apple is a much better deal than Amazon would be in that regards alright and lets take a look at one more here lets go with ATT all right nothing exciting about ATT for better for worse for an investor might be a good thing because its kind of overlooked so ATT has earnings per share of 5 and the price of that is 32 youre paying thirty two dollars is the price for a claim on five dollars of value this gives you a pe ratio of six right so at pe ratio six being less than ten would mean that this is an under priced stock it means that the ATT shares should be selling for more than 32 per share based on how much value theyre offering it which is five dollars so this would be an under price stock also sometimes people will call it undervalued which is a little bit and you know incorrect nomenclature but with a pe ratio of six this would be a better buy than either Apple or Amazon now if all this seems too simple thats because this is its a very simple way of looking at things this is a great introduction and a great way to start looking at stocks but there are multiple other things you have to take a look into including like what kind of dividend theyre paying you how much debt the company has can greatly change this price to book value and growth opportunities and well talk about these in future articles so thanks for hanging around guys thanks for viewing the article if you could open this link in YouTube if youre watching it in facebook and on the bottom right hand corner of the screen down here to see my area I kind of come down here hit the subscribe button like share it with your friends be greatly appreciated alright and until next time thanks guys

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