What is a P/E or Price to Earnings Ratio and how can beginners use it when investing in the stock market?
As a beginner in the stock market, one of the first investing concepts I learned about was the price earnings ratio or simply P/E. This ratio is simply a measure of how many multiples of a company's earnings you are paying for it's shares. This is useful because it provides a standard measure which we can use to compare the value of two or more companies. Using share price alone to compare various stocks is meaningless (I'll explain why a little later) - we need a way of comparing apples with apples. Price earnings ratios provide this mechanism.
All other things being equal, a stock with a lower PE ratio would provide better value than one with a higher PE.
How To Calculate Price Earnings Ratio.
P/E ratios are published in the financial pages of most major newspapers. They are also published online on websites like Yahoo Finance as well as the research areas of most online brokers. However, it can still be useful to know how to calculate it yourself. If nothing else, know how it's derived will help you to understand how to apply it to your investing activities.
The price to earnings formula is as follows:
Price To Earnings Ratio = Company Share Price / Earnings Per Share
The Company Share Price is the price that a company's stock is currently trading at. The simplest way to work out Earnings Per Share is to take a company's total earnings and divide by the number of shares on issue (technically you should make some adjustments to this depending on the company's capital structure, but I'll discuss this more in another article).
So if a company's stock is trading at $50 and it's earning $2 per share, then the price to earnings ratio for that company is 25 (50/2).
What Is A Good Price To Earnings Ratio?
As I said at the outset, one of the benefits of using P/E's to value companies in the stock market is that it enables us to compare apples with apples. If we take the example of two companies each trading at $40 per share. Using this information alone, can we determine if one is better value than another? No. The price is the same, but what do we get for that price? Now what if we take these same two entities and say that Company A has earnings of $2 per share while Company B has earnings of $4 per share. Not we can see that for the same price, we'd get twice as much earning power if we were to buy company B. The price earnings ratios would be 20 (40/2) and 10 (40/4) respectively. By comparing the PE's we can confirm that Company B with a PE of 10 is much better value than Company A with a PE of 20.
But what is a good price to earnings ratio? Well there is no simple answer to this. Some value investors advocate using a P/E of 10 as a benchmark. Others say that a P/E ratio of 25 is as high as they'd go. They are a number of way to use a price earnings ratio when investing in the stock market.
I think that it's best used in comparative analysis. Use it when comparing a group of companies. If you extend the example above from just 2 companies to an entire industry sub-group, you will quickly see where the value lies.
Another way to use the price to earnings ratio is to turn it upside down. This then becomes the earnings yield (earnings divided by price). To convert an existing P/E ratio into an earnings yield use the following formula:
Earnings Yield = 1 / Price To Earnings Ratio
So continuing on from the example above, a PE of 20 would give an earnings yield of 5% (1/20) while a PE of 10 would yield 10% (1/10). Now we can take this figure and compare it to returns from other investments. A useful benchmark is the long term Government Bond yield. If you can get a risk free return of say 7% from a government bond, this gives you a good benchmark with which to compare your earnings yield. I'll write more about earnings yields in an upcoming article.
What Are The Limitations Of P/E Ratios?
I must now stress that although this ratio is very useful, it must not be used in isolation. It should be used in conjunction with other measures of value, financial performance and stability. Apply it as a filter to create a short list of investment opportunities. I said at the start of this article that all things being equal, a company with a lower PE provides better value. While this is true, just remember that things are never equal. That's why you need to look at other things like debt levels and the ability to service debt, return on equity, return on assets and so on.
But as a beginner in the investing game, the price to earnings ratio is a good why to start exploring value in the stock market.
Tuesday, February 26, 2008
What are the best books about stock market investing for beginners?
In my recent article on stock market investing basics, I mentioned that stock market education was very important first step towards investing for beginners. In this article I want to take a look at some of the books I have found helpful in understanding investment principles and strategy. I've read a lot of investment books over the years and while they're all contributed to my knowledge to some degree, the following tomes are the ones that have stood out for me.
Having said that, I'm always on the lookout for new ideas so if you have any ideas - something you've read which stands out in your mind - then let me know. I would love to add a few more books onto my "to read" list.
The first investing book I'd like to discuss is The Intelligent Investor
Benjamin Graham is considered the father of value investing. He is credited with bringing discipline to the activity of security analysis. Before Graham, there was little structure in security analysis and through his writings and teachings he brought stock market investing into modern times. Although a successful investor in his own right, he is perhaps more famous for playing the part of mentor to a man who many consider to be the greatest investor of all time - Warren Buffett.
When I first read the Intelligent Investor, it was a revelation. Graham did such a great job of focusing your mind on what's important. He advocates stepping away from all of the noise in the stock market and instead concentrate on investment fundamentals. He concedes that over the short term, the market is a popularity contest. But over the long term, if you buy stocks at a significant discount to their intrinsic value, you should beat the market average.
What I like about Graham's writing is that he puts forward his ideas in a clear, concise and logical manner. He develops his arguments slowly but surely then counters any potential counter-arguments which may arise. He's also very strong in his research. He provides empirical evidence to support all of his main arguments. Although this book was first published over 50 years ago, I was astounded how relevant it is to today's market conditions. I highly recommend "The Intelligent Investor" by Benjamin Graham.
The next most influential investment book I have read is called Common Stocks and Uncommon Profits
Fisher thought the best results could be had by identifying the very best companies but studying the structure of the industry it operated in, management, commitment to research and so on. Price was less important as over time these companies would expand to many multiples of what you paid for them. What would it matter whether you paid $50 or $100 for a stock when in the future it will trade at the equivalent of $10,000 or more. Fisher's idea of having a small number of very high quality "growth stocks" was in contrast to Graham's theories of having a large number of heavily discounted stocks, but by reading both points of view, I think you will become a much better investor.
The last book I'm going to discuss in this article is One Up On Wall Street
One Up On Wall Street is a great read. It covers Lynch's first steps in the stock market, then takes you through his philosophy for choosing stocks. Lynch advocates sticking with what you know. He believes that we all comes across great investment opportunities everyday. We just need to keep our eyes open and be aware of the companies which operate around us in our daily lives. Lynch says that we have the opportunity the uncover these hidden gems and profit from them by buying in before the market at large becomes aware of the stock.
Lynch also categorizes the purchases he makes into one of 6 types. These are Slow Growers, Medium Growers, Fast Growers, Cyclical Stocks, Turnarounds - Special Situations and Hidden Assets. But I think what is more important than remembering the categories, is to understand why you are buying a stock. What do you expect from it? Do you expect to hold it for the long term? Will you hold it until some hidden value is realized. Or are you expecting a short-term reversal of fortune. I think this a very important concept. Understand why you are buying a company and know under what circumstance you would be willing to sell.
I decided to limit the list to only 3 books, partly because this article was long enough already, but also I didn't want to dilute the quality of the list. Don't get me wrong - there are a lot of other great investment books out there. Other books which just failed to make the cut include The Little Book That Beats The Market by Joel Greenblatt, The Warren Buffett Way by Robert G Hagstrom and The Money Masters by John Train.
There are also some great online resources which I'll cover in an upcoming article. But for now the above list should be more than enough information about investing in the stock market for beginners - and everyone else who hasn't read these books.
Sunday, February 24, 2008
Am I well suited to stock market investing?
Before embarking on a career as a stock market investor, beginners should be asking this question you should be asking yourself. I mention in my last article (How To Start Investing In The Stock Market) that before you get started, you need to be sure this is something you want to take on. In this article I will discuss some of the things you'll need to consider before deciding you're ready.
Are you emotionally ready for stock market investing?
Participating in the world's financial markets can be an emotional roller coaster ride. Anyone who's had any experience will know that prices can fluctuate wildly. And with this volatility, you need to make sure you will be able keep your head.
Imagine buying a stock, only to see it drop by 5% or even 10% the next day. What will you do? Will you panic and sell straight away? Or will you hold on secure in the knowledge that you've done your research and that over the long term the value of your shareholding will be realized?
It happens to all of us eventually. If you don't think you'll be able to sleep at night with all of this going on, direct investment may not be for you. You may be better off letting a professional manage your money. Stick with a mutual fund or something similar.
Do you have a long term investment time horizon?
Maybe I should clarify something here. I consider investment be be the act of buying stocks in quality companies at reasonable prices and holding for the long term. Short-term trading and speculation are fine - but you need to be aware of the risks. I don't consider these activities to be investment. It can be exciting but I would only employ a small amount of my capital in such endeavors.
Having got that out of the way, what I wanted to say was that you need to ask yourself how long you plan to be in the market. Are you planning to invest the money you've saved up to go on vacation at the end of the year? Or the deposit you've been saving to buy a house? If this is the case, the stock market probably isn't the right place for you. Consider cash or fixed interest investments.
You should be looking at a 3 to 5 year time frame - preferably longer. This will give you time to ride out any volatility associated with market cycles. Stock prices tend to oscillate around the intrinsic value of a company. If you invest in a company whose intrinsic value is rising over time, the stock price should eventually follow. The problem is that over the short term prices may fall short of this intrinsic value sometimes. And at other times it may even trade at a premium. You will need to give yourself sufficient time to ride out these periods of under-valuation. The last thing you want to have to do is sell out at one of the low points - especially if you think the intrinsic value of the company has increased over the period you've held it.
What is intrinsic value? This is a complex topic - beyond the scope of this article. I will write about this in more detail in a future article. But for now, let's just say that it's the true value of a company, rather than the value at which it is currently selling.
Do you have sufficient funds to invest in the stock market?
The reality is that you will need a certain amount of money before starting your stock market investment career. How much is enough? It depends. I would think about $5,000 to $10,000. But this could vary depending on how much additional money you can spare each month to add to your portfolio.
The idea is that you will need to diversify your holdings. You will need to buy stock in a number of companies to reduce the risk that a single company will under perform. If you're unlucky enough the own the next Enron, you want to make sure it's no more than about 10% to 15% of your total holdings. But there are costs associated with buying each of these holdings. You'll need to buy enough to make it worthwhile.
If you only have a small amount to invest, you may want consider fixed interest or a mutual fund until you have saved enough to take the plunge.
Are you willing to put in the time and effort to succeed in the stock market?
In order to be successful, you'll need spend a fair amount of time on your investments. You will need to spend some time getting educated before you begin. You'll need to spend the time researching the companies you intend to buy. You'll need to spent time monitoring you're holdings. This doesn't mean checking the prices everyday, but rather satisfying yourself that the fundamentals of each of your holdings remains sound from one period to the next.
While not an exhaustive list, the above questions should start beginners thinking about whether they are suited to stock market investment.
