Pearl Invest

Price Earnings Ratio (P/E Ratio) :

The price earnings ratio provides information about the earnings of a company in relation to the stock rate respectively the market capitalisation of a company. The price earnings ratio is interesting in order to get information about the how much profitability you get for your dollars. A rule of thumb implies that a price earnings ration of 15 is optimal a price earnings ration above 20 implies that the company is too expensive or we could say overvalues and a price earnings ratio under 10 is too cheap respectively implies that a company is often in trouble.

Ways to calculate the price earnings ratio:

For example, if a stock is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or “N/A”); sometimes, however, a negative P/E ratio may be shown.

Another way to calculate the P/E ratio would be:

For example if the value of the market capitalisation of a company is 1 million $ and the total annual earnings amount to 100000 $ the P / E ratio is 10.

But we have to be careful by using the P / E Ratio because of several reasons.

1. When the P / E Ratio of a company is very low it´s often the case the earnings of a company are going to fall and drag the low P / E Ratio below.

2. The values the P / E Ratio is calculated on are mostly values from the past which don´t reflect the current situation of the company anymore.

However what is the P / E Ratio good for ?

The P / E Ratio is always interesting when we want to have a quick and dirty look at the current estimation of a company. At the times of the dot-com bubble in the year 2001 we could see many estimations where the P / E Ratio was above 100. That means that the expectations to a company are very high, but the real earnings of a company didn´t correspond this high expectations, yet (in the most cases it´s also not very likely that they ever will). So the P / E Ratio can give us quick information weather a stock of a company is undervalued or overvalued.

In this Chapter we want to discuss why value investing works, but at first I want to do a little experiment. Image we trow a coin 6 times and everytime we do that we either get head (H) or a number (N), so what do you think which sequence is more likely to appear ? (H), (H), (N), (H), (N), (N)   or  (H), (H), (H), (H), (H), (H) the fact is that they are statistically completely similar. So what we can learn from this experiment is that the most people, despite they are well in numbers and stochastic would say that the first sequence is more likely to happen, because for them it´s not sound that the head of the coin appears six times in a row.

However why is this experiment interesting in order to understand why value investing works ? Well because that shows us that humans have their own subjective view of how the things are and these views are reflected in the sometimes strange movements of the stock markets. The Israeli psychologist Daniel Kahneman for example has won the Nobel price in economics for his work on behavioral finance, in which he discovered that irrational movements of the markets are the result of the collaborative opinions of single persons. Benjamin Graham the spiritual founder of the modern value investing described this phenomena with the help of the insane Mr.Market. He wrote, imagine there is a guy who comes to your home every day, just to tell you the price of your stocks. Actually this is a fine thing wouldn´t there be the fact that Mr.Market has a serious problem, because sometimes he is far too optimistic and tells you that your stocks will reach the heaven soon. And sometimes he is so the most depressive man in the world and predicts that your stocks will be worth nothing anymore soon. What Mr.Graham describes is just the behavior of the crowds. When they see that the markets are going up they want to participate on that, but when they see that the markets are falling they are feared to loose their money and start to sell their securities.

In order to explain how the reactions of the average investor are I took the following 10 years chart of the German stock index DAX.

1. The average investor starts to buy mostly overvalued stocks because he wants to participate at the rising markets.

2. The rally is over and the most winnings of the most average investors are zero again.

3. The average investor thinks that this was just a little break of the rally and buys again.

4. The markets are crashing the average investor sells his stocks and is frustrated.

5. Because the average investor is frustrated from his losses he made in 2003 his just starts to buy stocks in the year 2007 again and the whole game starts from scratch.

So the reason why value investing works is that value investors don´t care about subjective market fluctuations. Everything which counts for them are objective facts about the companies they buy. So the company is in their opinion undervalued because the for example the market capitalisation is worth far less than the actual assets of the company are.  Actually they don´t care about stock rates, because they know that they struck a bargain and on the long run the market will realize that.

The genius investor Warren Buffett once called it “buying one dollar for 70 cent”, the Margin of safety which was developed by the brilliant man Benjamin Graham in 1934. The precept of the margin of safety is very logic and works as follows.

Most people believe that the stock markets are rational, so that the stock-rate always reflects the actual value of a company. But that´s not true , you can prove that very easily. We you look back to the big ups and downs in times of a market crash. It´s definitely not logical that a company looses 60 % of its value and wins 120 % back in a short period of 2 years while the earnings constantly grow by 5 %. So we can conclude that the markets are irrational because sometimes the people become too afraid and sell very cheap stocks and sometimes they are just too optimistic and buy too expensive stocks. It´s not very intelligent but most people like to follow the herd.

But now, let´s get back to the margin of safety. If you know that the stock markets are irrational then why don´t make profit of it? First you look for very unpopular “cheap” stocks, the market capitalisation has to be far below the intrinsic value. That could be companies in trouble, after they reported bad news or complete industries with problems.

Now you calculate the value of the company in order to do that you can use different methods. 1. The Earning-capacity value 2. The Net asset value 3. The liquidation value. So for example, if you calculated that the intrinsic value of a company has the value of 100 Million USD, but the market capitalisation just lies at 70 Million USD, you get a margin of safety of 30% or 30 Million USD. You buy this stock and when the market capitalisation achieves the intrinsic value again you sell it.

Note: The margin of safety has not to be exactly 30 percent, but the higher it is the safer is the investment.