Comparative valuation sounds boring, but when you understand the premise you’ll realize it’s easy as hell. The problem you run into when trying to pick stocks is that you’re comparing apples and oranges all to often. Unfortunately, most newbies make 1 of 2 mistakes. The first is looking at the share price of a stock and deciding “well, that stock is way overpriced”. You need to realize that share price is only a small part of the equation. If you don’t know how many shares a company has, then you don’t know how much of the piece of pie you get when you’re buying a share. The other mistake is not having a method of comparing 2 companies like Apple and Walmart. Those 2 companies are NOTHING alike obviously, and without a way to compare them most people usually then revert to which has a cheaper share price. So how do you figure out which one is a better deal. THIS is where we get into comparative valuation. This one won’t hurt a bit.
Walter White* is laundering his meth money. He needs to find a company in that looks like a legitimate investment. Well, he’s a science teacher so he’s not just going to buy any crappy company out there. People will know he’s not buying a good investment. He’s narrowed it down to either buy Saul’s laser tag company suggestion or the car wash he used to work at. These two companies are nothing alike, so how the hell is he going to figure out which is a better investment. These are the 2 most common ways to compare companies…
The laser tag company is $500,000. It earns $75,000 a year. Earnings are sales/revenue for the last year minus all the costs of operating the company. It’s the money the company gets to keep. So the price/earnings ratio for the laser tag company is $500K divided by $75K. We get a P/E of 6.66.
The car wash is $800,000. It earns $160,000 a year. So it has a P/E of 5 (800K/160K)
So somebody new to investment will typically look at the two and say “obviously, 500K is the better deal”. But now we have a way to compare the two. Laser tag has a P/E of 6.66 vs the cash wash at P/E 5. When buying an investment you typically want to buy the LOWER P/E between two or more investments. In this case, the car wash (while more expensive in dollar terms) is the better deal. It earns more in relation to the price.
The next most common way to value companies is simply price vs sales. The only difference here is that instead of bothering comparing the money the company gets to keep, you just compare who sells more in relation to their price. The car wash is $800,000, but takes in $200,000 in sales every year. It has a price/sales ratio of 4 (800K/200K = P/S 4). Laser tag takes in $130,000 in sales every year. So it’s P/S is 3.85 (500K/130k = 3.85. Obviously, 3.85 is less than 4, so if you were valuing the companies just on sales, the laser tag company would be a better deal in this case.
Why Walter would value based on P/E vs P/S gets a little bit more advanced. If he compares the two based on P/E, the car wash is a better choice. If he compares the two based on P/S, the laser tag company is a better choice. As time goes on, you will figure out which is typically the best way to compare companies. In the beginning, we recommend just looking at Price/Earnings P/E.
A few of you are probably saying “that’s all well and good, but how do you compare companies when you’re buying stocks that have shares”. Simple, a company has a certain number of shares at any given point. So to compare the stocks vs buying a whole company you would just divide price of the overall company (it will be labeled as market cap) by how many shares are available. The good news is the price AND the earnings or sales will be divided by the same number (the number of shares doesn’t change). So NOTHING is different in finding the P/E or P/S with stocks/shares.
The good news is that looking at at the P/E of a company is so common that any stock site that you go to will have it already listed somewhere. Usually on the stocks main page or under a page called “valuation ratios”. Here’s an example on Yahoo Finance:
By the way the (TTM) means trailing twelve months. Meaning the number is based on the last year worth of earnings.
So that’s it… you’re done. You can go now…
*He’s from Breaking Bad. Why are you reading this instead of watching it?