Previously I wrote about the common misperception that a high-priced stock is “expensive,” while a low-priced stock is “cheap.” I said that stock price doesn’t matter.
This raises the inevitable question:
Q. How can you tell if a stock is expensive or cheap?
A. Use the Price-Earnings Ratio (aka the “PE Ratio”)
The PE ratio is computed by dividing the stock market price by earnings per share*. But it’s not that complicated: PE Ratio is often listed near the stock price. For example, check out Apple’s PE Ratio here. As I write this on April 20 it is 16.75. That means each dollar of net income will cost you $16.75 worth of stock.
An average PE Ratio these days seems to be in the mid-teens. You can consider high PE’s to be expensive and lower PE’s to be cheap. Therefore, Apple stock, compared to its earnings, is just about average. That’s right: Apple stock, trading at $593.85, is moderately-priced! (Pre-disclaimer – please read this whole article before calling your stock broker.)
Hewlett-Packard‘s stock price is $24.85 right now. But its PE ratio is just 8.77. Each dollar of net income will cost you just $8.77 worth of stock. Hewlett-Packard stock, compared to its earnings, is cheap.
Dell‘s stock price is $16.07 right now. PE Ratio is a low 8.52. Dell and Hewlett-Packard’s PE ratios may be so similar because the companies’ products are so similar.
Google is trading at $602.24 today. PE ratio is a moderate 18.25.
Let’s check out some other industries.
Goldman Sachs is trading at $113.71 a share right now. PE Ratio is a moderate 16.82. Citigroup is cheaper. While the stock is trading at $34.68, the PE Ratio is just 9.67.
Berkshire Hathaway is trading at $118.975 today. Think that’s expensive? Think again. The PE Ratio is a moderate-to-high 19.14. Investors are willing to pay a little something extra to have Warren Buffet working for them.
Let’s look at some really high PE’s:
Mall retailer Abercrombie &Fitch‘s stock price is $48.71. PE is a high 34.44. That’s expensive.
Manitowac Corporation makes cranes and food service equipment. Its stock is trading at just $14.64 but its PE Ratio is a humongous 71.62. “Low” stock price, high PE: an expensive stock.
While the PE Ratio is good measure for how expensive a stock is, it does not explain why the stock is expensive or cheap. A stock could be expensive (with a high PE) because investors are so frenzied to buy it that they don’t care about its performance – an obvious sign to stay away. It could also be expensive because investors have high expectations for the company – a good reason to buy.
And a stock could be cheap (low PE) because investors undervalue the company’s performance – this would be a good opportunity to buy low now and sell high later. On the other hand, the stock could be cheap because it is a really bad investment. It could go either way. Take a look at Dell and Hewlett-Packard. Their PE’s could be low because investors undervalue these companies’ prospects, or because they’re not good investments.
BTW: No one should ever make big money decisions based on what some stranger posts on the internet. This blog was not written to give you advice to buy or sell any stocks. I don’t own any of these stocks right now. Follow this blog, read other blogs, read books, check out www.finance.google.com, educate yourself, make your own decisions, and make your own money. Etc. etc. etc.
* You can use earnings per share for the past year, or even a prediction of earnings per share for the coming year.
[Image: $5700 by AMagill, on Flickr]