Quick tip: Yahoo Finance is a good place to get price quotes on stocks and their historical price charts.
Most students who have taken my financial literacy courses have wanted to learn as quickly as possible how to become a millionaire (or preferably a
billionaire) by investing in stocks and bonds. If this is your goal, lucky for you, as I can show you how to do it. However, you need to know how to evaluate stocks and bonds, and it takes time. To whet your appetite, in the next chapter, I show you how to become a millionaire by investing wisely in the stock market early in your career and then being patient. First, however, you need to understand how to evaluate stock prices.
The most used tool for assessing stock prices (that is, whether the market is overvaluing or undervaluing a stock) is the Price/Earnings Ratio (P/E Ratio).
This is the simplest formulation of this ratio:
Last year’s earnings per share means the total net income of the company divided by the outstanding number of shares. For example, the closing price of one share of stock you are looking at is $20.00 per share, and the earnings (or net profit) per share is $2.00. The P/E Ratio would look like this:
That means you are paying $10.00 for every $1.00 in earnings, or to put it another way, you are receiving $1.00 return for every $10.00 you invest. Your ROI could then be calculated like this:
To see if a P/E Ratio of 10 is a good, we need to look at the historical averages of the stock market’s P/E Ratios. I have summarized a few similar historical P/E Ratios below:
Table 13.3. P/E Ratios of S&P 500 Stocks
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To calculate what returns these P/E averages would give, plug the known numbers into the formula and solve for the unknown price. Then you can calculate the annual return. To simplify, we can assume that the earnings pre $1 per share.
If we paid $15.50 for one share of this company’s stock to own $1 per share of net earnings, our ROI would be:
In order to reconcile this with numbers we saw above, we need to add to use this formula:
The price appreciation of stock is a direct function of the annual growth in earnings per share, and the average annual dividend paid on the S&P 500 stocks is approximately 2%. However, P/E Ratios are volatile. Below is a chart of what is known as the trailing P/E Ratio of S&P 500 stocks from 1929 to 2019. The trailing P/E Ratio is an historical P/E Ratio; that is, it is calculated as such:
Note the volatility of the historical P/E ratio. It certainly gives us pause to think that we could predict the value next year with this tool, even though we have already discussed previously that the average of the trailing P/E Ratio from 1872 to 2015 is 15.5. Nevertheless, this data gives us the base for expected P/E ratios in the future. However, there are serious theoretical and practical flaws in projecting this historical P/E Ratio into the future, even on the average.
Figure 13.7. S&P 500 PE Ration – 90 Year Historical Chart by Fred Rowland is used under a CC BY-NC 4.0 License. Source: multpl data (12/2020).
Calculating the ROI for the average of the One Year P/E Estimate, we get the following:
Using the trailing P/E Ratio as a principle forecasting tool is flawed, due largely in part to the real world. Investors do not buy a stock for its past earnings but for its expected earnings and dividends. Simply, buying stock today does not entitle you to past earnings or dividends, but you will receive a proportionate share of future net earnings and dividends. Given an historical P/E Ratio of 15.5, investors are looking to buy a share of stock at a P/E Ratio of 15.5, but the earnings that are used to calculate the P/E Ratio are expected earnings based on the following year’s earnings. This P/E ratio is usually called the P/E Estimate and is calculated as follows:
Real world investors price stocks this way, causing a lot of the trailing P/E ratio’s volatility. Let’s say investors estimate that next year’s earnings will be $1 per share. If they want to buy a share at the average P/E Ratio of 15.5, they would pay $15.50 for each one. Now, let us say that they paid $15.50 for each share and were wrong about their estimate of next year’s earnings. The trailing P/E Ratio would be quite different from a P/E Ratio of 15.5. If the investor overestimated next year’s earnings and the earnings per share were $.50, the trailing P/E Ratio would look like this:
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If, on the other hand, the investor underestimated next year’s earnings and
earnings per share were $2.00 instead of $1, the trailing P/E Ratio would be this:
Estimated P/E Ratios can vary significantly across industries. Let’s say professional investors were able to accurately predict the one-year future earnings per share of the S&P 500 and that they were looking for a 6.5% return. The one-year P/E Estimate would be constant at approximately 16.5 times earnings. The high volatility of the one-year P/E Estimate simply attests to the fact that it is impossible to accurately predict future earnings.
The calculation of the ROI for the CAPE 10-year Price/Earnings Ratio is:
The Cyclically Adjusted 10-year Price Earnings Ratio (CAPE Ratio) is based on the average inflation-adjusted earnings from the previous 10 years. Nobel Laureate Robert J. Shiller created this ratio with economist John Campbell and detailed this in his book, Irrational Exuberance (2000). Shiller uses an inflation-adjusted (or real earnings) 10-year average is to smooth out the cyclical volatility of corporate earnings over periods of the business cycle. Divide today’s closing stock price by the 10-year real earnings per share and you have the CAPE 10-year P/E Ratio.
Below is a graph of the CAPE 10-year P/E Ratio compared to long-term interest rates. Note that even though the average CAPE 10-year P/E Ratio is 16.5 for the period 1818 to 2013, it is still quite volatile a measure of the value of stocks.
Figure 13.8. P/E Ratio compared to long term interest rates by Fred Rowland is used under a CC BY-NC 4.0 License. Source: multpl data (12/2020).