Hi, I’m Ian.
Two weeks ago, I did an online workshop known as ‘P/E Ratio Masterclass’. It is a 90-minute live session where I shared in detail what P/E Ratio is and how savvy investors use it to find growth stocks and to estimate total returns from investing in them. Link: P/E Ratio Masterclass.
Now, if you wish to have a 5-minute version of the Masterclass, read on. Here are the 7 key things that you need to know about P/E Ratio before using it on making your next investment decision.
P/E Ratio is the abbreviation for Price-to-Earnings Ratio.
It tells investors whether a stock is cheap or expensive by comparing its price with its earnings. For instance, if a stock has a P/E Ratio of 10, it means that a stock is priced 10 times of its earnings. In other words, if I choose to invest in it, I am investing RM 10 into a stock for every RM 1 it is making a year.
P/E Ratio Formula:
= Stock Price / Earnings per share
#2: Why Low P/E Ratio
Ideally, investors aim to buy good stocks at their lowest possible P/E Ratio. A good stock is one that had grown profits consistently and has the capabilities to grow profits in the future. Here, I’ll explain the reason why savvy investors prefer stocks with low P/E Ratio over ones that have high P/E Ratio.
Let us consider two stocks: A Bhd and B Bhd.
A Bhd’s P/E Ratio is 10. Meanwhile, B Bhd’s P/E Ratio is 20. Thus, an investor would consider A Bhd to be cheaper than B Bhd because:
- If I invest in A Bhd, I am investing RM 10 for its stock for every RM 1 in earnings a year. Hence, my Return on Investment (ROI) works out to be 10% per annum. (ROI = RM 1 / RM 10 x 100%)
- If I invest in B Bhd, I am investing RM 20 for its stock for every RM 1 in earnings a year. Hence, my Return on Investment (ROI) works out to be 5% per annum. (ROI = RM 1 / RM 20 x 100%)
Return on Investment (ROI) Formula:
= (Earnings per share / Stock Price) x 100%
#3: Cheap vs. Affordable
There is a difference between cheap and affordable. What is affordable may not necessarily be cheap. Of course, what is cheap may not be affordable to some people. Let me use an analogy to explain the difference:
Supposedly, we have two properties: A and B. The selling prices of Property A and Property B are RM 300,000 and RM 400,000 respectively. Would you say that Property A is cheaper than Property B?
Most likely, you would ask for ‘Extra Information’ such as location, size, and other considerations which are of importance to yourself. Right? Here, let us keep it simple by using size on a per square foot basis. What if, I tell you that the sizes of Property A and Property B are 300 sq. ft. and 1,000 sq. ft.?
Based on size itself, Property A is priced at RM 1,000 per sq. ft. and Property B is priced at RM 400 per sq. ft. As such, we may conclude that Property A is more expensive than Property B despite being more affordable.
It is the same concept with stocks. Let me give you an example.
Now, we have two stocks: C Bhd and D Bhd. Their details are as followed:
Price = RM 25
Earnings per Share = RM 2.50
Price = RM 0.50
Earnings per Share = RM 0.02
Which of the two is cheaper? The answer is C Bhd as its P/E Ratio is lower at 10 as compared to D Bhd whose P/E Ratio is 25. Hence, an investor may view that C Bhd is more attractive than D Bhd as an investment. If you are reading this and still could not grasp this concept, please reread the analogy above & take some time to ponder it before investing. So, once again, between C Bhd and D Bhd,
- C Bhd is Cheaper but Less Affordable.
- D Bhd is Expensive but more Affordable.
#4: Who Uses P/E Ratio?
P/E Ratio is best used for stocks that have the ability to compound investors’ wealth. Thus, it is meant for:
- Growth Investors, the Warren Buffett kind of Investors
- Buy, Hold, and Accumulate More … if stocks are cheap (Low P/E)
- Dividend Investors, compounding dividend income.
Who is it not for – Speculators. Gamblers. Traders. P/E Ratio is pretty useless for these group of stock market participants as it is not relevant.
#5: What Kind of Stocks are Ideal for P/E Ratio?
I’d explained briefly in Point 2 of what a good stock is. Let me expound on it again. Ideally, a good stock must fulfill three basic criteria:
- Past: Grown Profits Consistently.
- Present: Healthy Cash Position & Balance Sheet Strength.
- Future: Have Growth Plans to Expand in the Future.
These stocks are ones that are more likely to compound investors’ wealth for the long-term, thus, ideal to be evaluated using P/E Ratio. You may ask, ‘How about stocks that do not grow profits consistently? Are we to dismiss them as potential investments?’
My answer: ‘Why would you want to invest in stocks that do not grow profits consistently when we can find stocks that can in the stock market? As I write now, there are 900+ stocks listed on Bursa Malaysia, 700+ stocks on the SGX, and 10,000+ stocks in various exchanges in the United States. So, why do you want to settle for anything lesser?’
Here is a golden tip: Investment is not just about making money. It is about a plan to build wealth as safely as one possible can.
#6: Why 10 Years P/E Ratio?
Savvy investors would calculate a stock’s both the current P/E Ratio and P/E Ratio for the past 10 years to properly ascertain whether a stock is really one that is cheap or expensive. Why 10 years?
This is because it measures a stock’s income stability over a 10-year period. If a stock has 10 years of P/E Ratio, it indicates that a stock has a track record of profitability and has proved itself to remain resilient against any economic & political situations during the period.
#7: Use P/E Ratio to Estimate Capital Gains before investing into a Stock
Continuing from above, it is possible for us to estimate a stock’s capital gains by using P/E Ratio. This involves a life demonstration which I’d shared in my online workshop, P/E Ratio Masterclass.
Once again, here is the link: P/E Ratio Masterclass.
If you have watched the videos, try as a ‘homework’ on the following stocks:
- LPI Capital Bhd
- Hartalega Holdings Bhd
- Carlsberg Brewery Malaysia Bhd
The above are not intended to be a recommendation to buy or sell any stocks but are intended as a ‘test-run’ so that you can learn and be familiar with the formula presented in the P/E Ratio Masterclass.