P/E Ratio? What’s that you ask? Sounds complicated right?—some kind of stock market lingo that is too hard for you to understand.
Not quite. That’s what Wall Street wants you to think.
After all, if everyone knew what P/E ratios were, far fewer individuals would invest in the stock market.
The P/E ratio is short for price-earnings ratio. It is simply the ratio between the price of a company and how much it earns. Here is how Investopedia describes it:
“Suppose that a company is currently trading at $43 per share and its earnings over the past 12 months were 1.95 per share. The P/E ratio for the stock could then be calculated as 43/1.95, or 22.05.”
Another way to describe this ratio is simply the valuation multiple for a given company.
Over the last 5 years, Yelp.com has averaged a P/E ratio of about 560.
What does that mean? It means that that for every one dollar earned by Yelp earned by the company, the company has been valued 560 times that on average over the past five years.
So, if Yelp.com earned $500K in a given year, the valuation given to it would be about $280 Million.
I’ll tell you one thing, I would gladly sell any of my business for $280 million and they make more than $500k per year!
Now, who would be foolish enough to pay so much for a company?
Well…anyone who invests in Yelp.com!
Actually, if you look at any stock that is publicly traded, valuations tend to be much higher when compared to small businesses.
To a certain degree, it makes sense for publicly traded companies to have higher valuations. They tend to be bigger and more stable then your typical mom and pop operation.
So… it’s going to cost you more to have less risk—at least that’s what you think until the market drops by 40 percent.
On the other hand, a typical business you might buy yourself will typically have a P/E ratio of 3-7. In other words, if you see a business for sale and it’s earning about 500K per year, you may very well be able to buy that business for under $2 million—not $280 million.
Now what sounds more appealing to you? Where are you getting the better deal?
You might be thinking to yourself, “Sure, but I don’t want to manage a business”. That’s may be true, but does that mean you can’t invest in someone else’s private business?
How about real estate? Real estate is considered one of the most stable assets out there—not a lot of operations and volatility like your typical business.
Right now, we are at the top of the market cycle. Real estate is expensive these days!
As a real estate investor, I’m looking for high quality 100 unit plus apartment buildings in Dallas.
Despite being at the TOP of the market cycle, significant assets are still being priced at less than 20X profits (cap rate of 5 or better).
When you think of what people are paying in the stock market, that doesn’t sound so bad anymore does it?
That’s because most people aren’t paying attention to the math.
Do me a favor and start looking at your investments in the context of price/earnings ratio and let me know what you think.
It will change the way you look at your investments.