Stock market analysis websites are packed with data. New investors get overwhelmed with the onslaught of information available instantly through the internet, but comparatively few investors actually know what to do with it. Some investors go with their gut, investing in companies they are familiar with or that they think will experience lots of growth in the future. But is there a way to know that a company stock stands a good chance of gaining value in the coming months and years?
Today, I’m going to show you how to take a stock data site and find valuable information that you can turn into real earnings.
To do this we’ll learn a simple stock evaluation tool taken from the playbook of value investors like Warren Buffett.
What is Our Goal?
Value Investing is just one approach to stocks and bonds. There are many other ways to invest, but this approach is about identifying stocks and bonds that are valuable and steady. Stocks like this will provide reliably high returns for as long as you hold them.
There is a mountain of data presented on stock market websites. You don’t need to know what it all means to figure out whether individual stocks are worth your time. Checking the Motley Fool latest stock pick can help.
Important Terms to Understand if You Want Stock Data to Make Sense
The two terms we’re going to talk about today are “P/E Ratio” and “P/B Ratio”. These two terms reveal a stock’s long term prospects in your portfolio.
P/E Ratio – This ratio is listed for every stock, on every stock evaluation site on the internet. It is the price of the stock divided by the annual earnings of that stock. For example: if you bought a $100 from a company, and that stock brought you earnings of $20 each year, the P/E Ratio for that stock would be 5.
$100/$20 = 5
Another way to think about P/E Value is that it is the number of dollars you will have to invest to earn $1 in a year. Therefore, in the example above, you would have to invest $5 in that stock to earn $1 in a year. That’s a 20% return. That’s pretty great! When looking at P/E Ratio, always remember: lower is better for annual returns.
P/E Ratio is helpful for understanding your immediate prospects when owning a stock. But how stable is the company you’re invested in? To understand that, P/B Ratio is one of the most effective tools.
P/B Ratio – The P/B ratio is the Price of the stock divided by the Book Value of the stock. You already know what the price is, but what is book value? The book value tells you how much equity you get in a company when you buy one of its shares.
Equity is how much of a company’s value is owned by the company itself. A company might be very large and complex, but not actually own the assets that contribute to its value. An example of this is Tesla: very valuable company with a ton of debt.
You want as much book value per share as you can get. If the company you are invested in were to be sold tomorrow, it represents how much money you would be paid back, per share. When it is expressed as the P/B Ratio, you learn how many dollars you would have to invest to have $1 in Book Value (equity). As with P/E ratio, lower is better.
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The Inverse Relationship Between P/E Ratios and P/B Ratios
The thing is, it’s hard to find a company that has a low P/E Ratio and a low P/B Ratio. That’s because companies that give their investors high earnings (identified by a low P/E Ratio) are choosing not to invest that money back in their company. The result will be that the company is more likely to be in debt, even though they are making tons of profit.
A company with a low P/B Ratio is probably using their revenue to build equity. They’re paying off debt, building new systems, and generally investing in things that will make the company more valuable. Amazon is a great example of this. Their investors don’t get much in the way of dividends, but people invested in Amazon stocks have seen the prices soar over the past several years.
Ideally, you would invest in a company with low P/E and low P/B. This company would give you a lot of dividends each year, but would also be very secure in terms of equity just in case the company went out of business or experienced some kind of disaster. It’s hard to find companies like this, but that’s exactly what value investors do. They look for high long term earnings, without much risk of failure in the years and decades to come.
Warren Buffett’s Multiplication Trick
Warren Buffett made a rule many years ago that he wouldn’t think about investing in a company with a P/E Ratio higher than 15 ($15 invested to get $1 in earnings each year). He also decided he wouldn’t consider investing in a company with a P/B Ratio higher than 1.5 ($1.5 dollars invested to get the security of $1 in equity).
He started multiplying those numbers together for all stocks he was considering investing in. I’ll save you the math. The result is 22.5. Companies that spat out numbers higher than 22.5 were not worthy of consideration to Buffett. Companies that had lower numbers were worth careful consideration.
Try this out yourself. Look up some stocks, and try multiplying the P/E and P/B of the stocks you’re interested in. The stocks that you find have great long term prospects. These are companies that have been around a long time, and are probably going to be around a lot longer. They have a great deal of equity and they make reliable revenue each year.
As I said earlier, this is not the ONLY way to invest. It’s just a simple tool that’s part of a conservative investment philosophy held by a number of very successful investors. Understand it. Build on it. Let it work for you. There’s a lot more to learn when it comes to understanding the complex data presented online, but we’re one step closer by understanding and applying P/E and P/B ratios.