This is part 1 for examining company performance.
Strtaight to the point, I have compiled a guide telling you what P/E ratios you should put in your stock screener, inlucing what most people forgot to tell you about P/E ratios.
I believe in giving complete information, so read on below. It will surprise you.
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What P/E Ratio Measures
The price-to-earnings (P/E) ratio is a financial metric used to evaluate the relative value of a stock.
It compares a company’s current stock price to its earnings per share (EPS). The P/E ratio is calculated by dividing the current market price per share by the EPS.
The P/E ratio measures how much value an investor gets relative to what they are paying for, investing into a company.
In simple terms, a high P/E ratio indicates that a stock is overvalued, e.g. I’m paying too much given the stocks value.
While a low P/E ratio indicates that a stock is undervalued, e.g The stock is cheap to get given its value.
We want undervalued stocks wherever possible.
P/E ratio should not be used in isolation and should be considered in conjunction with other financial ratios.
What People FORGOT TO TELL You About P/E Ratio
Industry Variance:
P/E Ratio varies across industries!
It is important to compare a company’s P/E ratio to the average P/E ratio of companies in the same industry. E.g, different industries have different growth prospects, and therefore, different P/E ratios.
For example, companies in the tech sector often have higher P/E ratios than the utilities industry, as technology companies are expected to have higher growth prospects.
The key is to find a company that have either the same P/E as their industry, or lower
Some examples of P/E ratios by industry sectors are below.
Business Cycle Variance:
P/E ratio also varies with the stage of the business cycle.
During an economic downturn, the overall P/E ratio of the market tends to be lower as investor’s sentiment is generally low.
During an economic boom, P/E ratio tends to be higher as investors are optimistic about the future.
Below is the S&P 500 P/E ratios across 5 years.
P/E Ratio Values to Put in Your Stock Screener
Now, If P/E varies across industry and business cycle, then what number should we put in our stock screener?
A good number to start with is to look for companies with a P/E ratio of 20 or lower.
Well known index funds such as S&P500, VanEck Semiconductors, Health Care Select SPDR, etc have index funds hovering or below 20.
Warren Buffet’s personal choice is to look for P/E ratio of 15 or lower.
However, if the industry you want to invest in have higher P/E ratios (well above 20), it is ok too. Some industries have P/E ratios well in the 30’s due to their expectation of high growth.
From here, we can use other financial ratio analysis to uncover more stories about the company. I’ve summarized the above on the Quick Wins section below:
QUICK WINS
P/E RATIO VALUES TO USE
STEP 1 :
Use P/E Ratio of 20 or lower as the first pass, and see what companies are listed.
STEP 2:
Use P/E Ratio of 15 or lower following Warren Buffet’s criteria as a second pass. See is there any interesting companies that meets it.
STEP 3:
For industries with specific P/E ratios, use the average industry’s value, ex: 9.66 for Banks, 33.74 for Aerospace, etc. There are many resources to find this, one of it is here>>
RULEBOOK
DO NOT USE P/E ratio in isolation :
Always compare a company’s P/E ratio with its industry average.
High P/E Ratio – Overvalued, e.g. I’m paying too much given the stocks value.
Low P/E Ratio – Undervalued, e.g The stock is cheap to get given its value.
DEALING WITH VARIANCE
Economic Crash – P/E ratio tends to be lower, investor’s sentiment is generally low.
Economic Boom – P/E ratio tends to be higher, investors are optimistic.
One Line from Peter Lynch That You Should Take to Heart
As an investor whose on track to reach $10,000,000 for my retirement, I can tell > 90% of people doe’s not follow the industry standard way to invest.
Peter Lynch>> said:
“Investing without knowing risk management, is gambling.”
E.g. people always analyze the wrong performance criterias and also disregard market risks. They are have the exact same chance of winning in the casino (0%) where the house always wins.
I always stress that investment performance depends on how good your analysis and your risk management is, if you have read my insights on other topics:
That is why I developed SFA Investment Class.
A one-year guided class and mentorship in which my students learn about all the important criterias and risk management, so that they are equipped to manage their investment themselves.
In the program, I give :
- In-depth stock investment knowledge that leaves no stone unturned.
- One-on-one mentoring that guides my students through the entire process.
- Action Plans for applying what my student’s learned to real-world investments.
- Practical Tips.
- Weekly updates of current economic and investing insight.
I also put my students in a private Whatsapp group where they will meet others in the same situation as them, as well as having direct access to mentors and group discussions.
I like to promote the spirit of camaraderie in investments, as I feel is few and far between in the industry.
Some of my students now are doing investment together where they analyze different stocks from multitudes of industry, collate the analysis, rank the top performance, and invest there. Its great to see.
Anyways, if the above program fits you, I would like you to be part of the team>>
I guarantee that within the first two months, you will feel far more confident about your investments, and have a solid plan in place to achieve your financial objectives.
Either I’see you in the class, or in the next article.
Until then..
James Lim
SFA Founder
Member of Australian Investors Association (AIA)
The University of Queensland Speaker
