Is the company with the lowest PE always the best investment?
Suppose you went shopping for a new car. The dealer showed you two different cars. One costs $50,000 and the other costs $6,000. Which one is the better value?
Hopefully, you'd say you need a bit more information first. Sure one car is cheaper, but if it breaks in a month, you'd hardly call that a good value. Furthermore, if the expensive car required no gas or maintenance for the life of the car. and it could cook you breakfast while you drove, you might have found quite a valuable car. Naturally, it is safe to say that you should expect quite a bit more from the $50,000 car than from the $6,000 one.
Shares of stock are no different. Remember, for the sake of this example, a company's price tag is not the share price listed in the newspaper; it is the P/E ( Price to Earnings) Ratio. Earlier we stated that when investors buy shares, they are showing their confidence in a company's future. Buying causes the share price to rise, increasing the P/E ratio. The P/E ratio is absolutely essential in determining a company's price tag. But remember that a P/E is a look at the current share price and the past earnings.
Imagine two companies with the same EPS numbers. You might imagine that these two companies should have roughly the same share price since they are both making an equal amount of money per share price. But what if everyone agreed that Company A is growing a lot faster than Company B. You would expect investors to buy more of company A, raising the share price, and thus Company A would have a higher P/E ratio. This is no different than paying more money for brand name goods over generic ones - you are expecting a little more out of them.
You might be asking, "If we need to focus on the future, why am I bothering to learn a P/E that represents the past?" Resist the temptation to treat this ratio as insignificant. It is extremely important. One of the most important predictors of future earnings is past earnings. In other words, investors will want to see the EPS growth of past quarters to determine an idea of the growth of company. It is also important to see if the share price (and PE) has grown in line with the EPS.
So, it is important for investors to look to the past and the future of a company. A successful investor will try to determine a projected growth rate for each company she is considering. Usually this yearly percentage increase is a look into the company's future for the next 3-5 years.
Naturally, each investor tries to determine growth in their own way using a variety of data. Some of the more common include:
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The EPS (Earnings Per Share) growth rate of past quarterly / yearly earnings:
- EPS 1996: $0.51
- EPS 1997: $0.98
- EPS 1998: $2.00
- EPS 1999: $4.06
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A professional analyst's opinion and/or computed estimate for a business or industry
- Corporate USA analyst, Clair Voyant, announced that her prediction for Apple Computer's EPS will be $1.36 for next year, up from this year's projected EPS of $1.14.
- BankWise analyst, C. Itall, announced today that he predicts over $450 million in total cell phone sales for the future year of 2005.
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Changes in technology
- World leaders today signed an agreement protecting the world's rain forest from further deforestation. At the end of this year, all logging companies will cease operations on protected rain forests .
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Local, national, or international news
- World leaders today signed an agreement protecting the world's rain forest from further deforestation. At the end of this year, all logging companies will cease operations on protected rain forests .
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Changing social norms
- The yuppies of the 1980s, Generation X, the recycling movement, etc. How have these affected business operations?
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Other investors' perceptions
- The "buzz" in the investing world is the new software start-up company devoted to aiding the breakdown of subatomic nuclear particles. While it is uncertain how many investors truly understand the business they are investing in, it is hard not to buy some shares when everyone is saying how wonderful it is. Besides, the share price has gone from $6.00 to $71.00 in six weeks.