The PE ratio

Education Pt. II

I cannot stress how important it is to educate yourself before taking the plunge into the stock market. If you do not care about educating yourself, it will be more like taking a plunge into shark infested waters. You WILL get eaten alive! This is why I am continuing the 'Education' segment today with the basic practices of the PE ratio along with a few tricks I have learned. The PE ratio is just one of the many weapons we investors have to judge a company. The PE ratio is a very good indicator of whether a company is over or under valued (hopefully you now see why this is so important).

But what is a PE ratio?

The PE Ratio or the Price to Earnings Ratio is the price of a company’s share divided by the company’s earnings per share (EPS). Say a company has a share price of $50 and an EPS of $2; this gives them a PE ratio of 25. Ideally, you want a company with a low PE ratio. The average PE ratio for an S&P 500 company is about 15. Though you want a company with a low PE ratio, a higher PE ratio does not mean the stock price will not go up.

Is their PE ratio too high?

If the company is a fast grower (+25% growth for the next 5 years) it is acceptable to have a higher than average PE ratio. If you thought Chipotle’s (CMG) PE ratio was too high at 30, which is a bit overvalued for a restaurant, you would have missed out on the 100% return the ensued. Another example is Starbucks (SBUX). Until recently, they were usually boasting a PE of about 40, which is a bit above average for their industry, but take a look at their chart since their inception in early 1990’s. I think we can both agree that they did better than okay.

Is it too high yet?

When the PE is high enough for you to drop your jaw, like in the case of Jones Soda (JSDA), and the growth and earnings guidance is not there to bail you out, run. Jones Soda had a very impressive run that shot from $12 a share to more than $30, only to come crashing straight back to reality. When their stock price was more than $30, they were hauling around a PE of more than 300, with a next year PE of 90. One of their nearest competitors, Hansen Natural (HANS), is still in the growth stages of their company and ironically shares almost the same 5 year growth of about 30-35% as Jones Soda. And what was Hansen’s PE during all of this? Their PE was and still is a very sustainable 40 with a forward PE of 20. What gives Jones Soda’s stock the privilege to be valued more than 7 times as much (according to the PE ratio) as a successful company such as Hansen? This formula, along with shrinking guidance, equated to Jones falling right back to where they belong. The same goes for Blue Nile (NILE), which sports a PE of almost 90 and a forward PE of 60. I was backing this company when it was worth $30 a share with a PE of about 30 and it is now at $80. It's time to let go (Pigs get slaughtered)! Blue Nile will not have the same catastrophic crash as Jones, because their PE is not as outrageous, but I am looking for a bit of a pullback.

Final Thoughts:
- Use the PE to let you know whether the company is overvalued or undervalued.