P/E and Why it Took Me A Year To Get This Ratio

I actually began this series of posts by trying to fit the definitions of P/E, P/B, P/S and P/CF in one post.  I failed. If you write about P/E and leave out the fact that a low P/E could mean BOTH a great investment or a lousy company, you run the risk of leading someone astray.  I’d hate to do that.  In fact, I’d rather give a pretty comprehensive overview of these ratios then risk misinforming for the sake of brevity.  Therefore, you will get four posts dear reader.  Congratulations?  I guess? Moving on:

Analysts and stock-pickers love comparing the price of a stock with some other arbitrary company valuation.  If you’ve spent any time on Morningstar or Yahoo Finance, you’re guaranteed to see P/E, P/B and will probably see some form of P/S or P/CF.  So what do all of these P/X ratios mean?  Very simply, Price/Something.  The denominator of the ratio changes with the whims of the analyst.  You can even make up your own P/X ratio at home.  For example, Price/Operating Income.  Congratulations.  You just added another ratio to the pantheon of P/X ratios.  For today, we’ll begin with the every-popular P/E ratio:

P/E or Price/Earnings: Price of the stock per share divided by the earnings per share.  This is by far the most common price multiple. Usually anything below 15 is considered cheap, but you must always compare a company’s P/E to some benchmark (preferably industry). P/Es can vary greatly by industry.  Some industries like tech and bio-research can have P/Es in the in the triple digits.  This means that people are willing to pay $100+ for every dollar that the company earns.

So I hear you thinking “What does that mean?”  That means that investors are expecting the company to make a lot more money someday.  However, this expectation can keep a stock’s price relatively high for years.  Still some people see a high P/E and run the opposite direction and for good reason.  When a company has a high P/E, the chances of the company being under-analyzed and under-bought are slim to none.  A high P/E means the market is waiting patiently for the company to break out and meet everyone’s earning expectations.  However you know what happens when everyone has high expectations for something.  When the something fails to meet the expectation, everyone’s disappointment is magnified. Failed expectations are no different in the market.

You also need to compare a company’s P/E with previous years P/Es for the same company, because accountants can greatly inflate one-time yearly earnings (which subsequently lowers P/E).  For example:

Delta

Via Yahoo Finance

Is Delta’s P/E actually 3.18?  Yep.  Is that an accurate representation of Delta’s stock’s value?  Absolutely not.  In 2013 Delta wrote off nearly $8 million in income tax expense.  This write off increased their net income by approximately 10 times the net income of 2012 (which subsequently increased the earnings per share by 10 times).  You don’t need a PHD in Math to see what this does to the P/E ratio (30/10 = 3 BUT 30/1 = 30).  Remember, when you’re looking at P/E ratios, most of the time you want a lower P/E ratio, otherwise you’re paying for growth.

HOWEVER a low P/E ratio doesn’t guarantee a company is a good buy.  The company could just be a lousy investment.  You must always take the P/E ratio with a grain of salt.  Remember, if choosing a stock was as easy as grabbing a stock with a low P/E then how come everyone isn’t doing it?  Because it’s sometimes a poor idea.

All things being equal, you’ll want a low P/E instead of a high one, only because the up-side of a low P/E is infinitely greater than the up-side for a company like Amazon.  You want to have high returns on the market, and you accomplish this by choosing stocks that only go up in price.

Finally, if a company earns no money for the year, then the company has no P/E.  Take Tesla for example.  No profit (yet) so no earnings per share and no P/E.

via Yahoo Finance

via Yahoo Finance

So, why did it take me a year to understand P/E? It’s extremely simple, but the ratio’s simplicity makes it extremely versatile.  Every time you think you understand it, someone will come along and say that “P/E means this!”* and you’ll have to reevaluate everything you thought you knew about the ratio.   If it takes you sometime to fully understand it, just keep in mind that I took much longer than the average person, and I blog about it now, so that must mean I know everything there is to know about finance (sarcasm).

*For example, if you flip P/E you arrive at earnings yield, which is another way of stating the percentage of earnings the stock earned per it’s price.  Amazon, for example has an earnings yield of .18% (not a typo), while Delta, with its inflated earnings, has an earnings yield of 31.4%.  See why you don’t want to purchase a stock with a high P/E?

 

 

Measuring the Russell 2000′s Effect on the S&P 500 (WOO-HOO)

I know almost nothing about statistics, so this post should be fun.

On my post a few days ago, I wondered how a proverbial devaluation of small-cap stocks (i.e. Russell 2000) would effect the valuation of large-caps (S&P 500).  To figure out the answer to this simple question, I must run some elementary statistics.

As I stated earlier, I’m no statistician, so you shouldn’t use this post as an introduction into statistics.  In fact, I may have something totally wrong, so please correct me if you see something missing in my methodology.

For this comparison, I gathered the monthly returns for the S&P 500 and the Russell 2000 since April 1980.  I set up the two data columns in Excel and ran a regression analysis (fancy term for I’m not really sure).  This is what I found:

Russell 2000 vs. S&P 500

Russell 2000 vs. S&P 500

So what does this mean?  This chart shows that the correlation between the S&P500 and the Russell 2000 is .73.  For the uninitiated, correlations measure a relationship between two random variables.  If two sets of data have a correlation of 1, then the two sets of data correlate directly (meaning when one variable goes up, the other variable goes up as well); however, if two sets of data have a correlations of -1, then they correlate inversely (if one variable goes up the other variable goes down).  If two sets of data have a 0 correlation, that means that they have no relationship at all.  If you’re looking to diversify your portfolio, you want to choose two sets of data that have a 0 correlation.

Of course, this may be the worst description of correlation in the history of statistics, but it allows me to show that the correlation for the two indexes is fairly high.  If I was doing scientific research, I would be somewhat excited about two variables having a correlation of .73.  This also means that 53% of the time that one variable goes up, the other variable goes up as well.  Not too shabby.

However, there are probably a dozen readers rolling their eyes right now and saying under their breath “Big whoop”.  They would be right about their observation.  I have discovered nothing new, I expected the S&P 500 and the Russell 2000 to have such a high correlation, but I also wanted to check my assumption because sometimes things you assume to be true may not have 100% accuracy.  In fact, I expected the two data sets to have a higher correlation, so I’m glad I checked.

Also, I’ve shown that the two indexes do not necessarily have a 100% correlation.  Sometimes the S&P 500 will rise and the Russell 2000 will not (or vice versa).  You may or may not be able to use this information when making investing decisions, but knowing how to check correlation between two different data sets gives you the power to double check what everyone says is truth and maybe discover a few things for yourself.

Disclaimer: This is not investing advice.  This is not statistical advice either.  In fact, I would definitely pick up a book if you want to learn more about stats.  Please double check everything you’ve read in this post, and then let me know how wrong I am.

 

Of course it’s the Russell 2000, but what does it mean?

I wrote yesterday that the P/E ratio for the Russell 2000 seemed high.  My only benchmark for this observation was that the P/E for the Russell 2000 was nearly double the index’s previous year P/E ratio.  While I know such observations are far from groundbreaking, I would like to delve into the Russell 2000 and the implications of high multiplier for a not-very-popular index.

According to the Wikipedias

“The Russell 2000 is by far the most common benchmark for mutual funds that identify themselves as “small-cap“, while the S&P 500 index is used primarily for large capitalization stocks. It is the most widely quoted measure of the overall performance of the small-cap to mid-cap company shares. The index represents approximately 8% of the total market capitalization of the Russell 3000 Index.”

So the Russell 2000 covers small-cap (companies worth less than $5 billion).  Interestingly enough, these companies only represent 8%  of the market-cap of the Russell 3000 (basically the broadest view of the American market) despite the fact that they make up 66% of the companies on the index.  If these companies are overvalued, having these companies lose a lot of value wouldn’t put a huge dent in the market theoretically.

However, and here’s a great example as to why you should always check stats, the Russell 2000 webpage states that the P/E for the index is actually 21.26 (see below).

Index characteristics
Price/Book 2.18
Dividend Yield 1.31
P/E Ex-Neg Earnings 21.26
Long-Term Growth Forecast – IBES 13.52
EPS Growth – 5 Years 13.14

Needless to say, 21.26 is a far cry from 78.20.   I would usually trust the Wall Street Journal, but I’m wondering where they came up with a P/E near 80.  Did they subtract negative earnings from positive earnings to create a bloated P/E?  That’s my guess, but I’m much more likely to believe 21.26 than 78.20.

While small-caps seem slightly overvalued compared to the S&P 500, I wonder how a drop in the valuation of small-cap stocks would effect large-caps.  Less competition?  More earnings?

Via https://www.russell.com/indexes/americas/indexes/fact-sheet.page?ic=US2000

Via https://www.russell.com/indexes/americas/indexes/fact-sheet.page?ic=US2000

Whatever the case, small-caps have been hit pretty hard over the last few months (I kind of feel sorry for them), maybe this is a sign of a less-healthy market, or maybe people don’t want to take on risk when everyone is expecting a correction.  Either way, the market correction or bear market, if there is one, may have already arrived for the small-cap world, but everyone seems too focused on large-cap to notice.

Disclaimer:  I really love you all.  I really do. But please do not use this blog post as investing information.  I don’t want you think that this is investing advice and use it to actually make decisions regarding money, that would not be very smart and I don’t want to assume responsibility (i.e. liability) for such a bad decision.  I’m glad we talked.

What to make of this market…

Everyone seems to be cautiously waiting.  Waiting for something that will “correct” the market.  Why? The market just seems too high.  I agree.  I don’t like the looks of the chart below:

From Yahoo Finance

From Yahoo Finance

A cold chill runs down my spine when I see the recent returns for the S&P 500.  The last few times the stock market rose that much, the market crashed a few months later.  Babies cried.  People lost money.  Things were bad.  So everyone has learned from the last time the market grew this much right?  There has to be a bubble somewhere fixing to explode.  Everyone knows this.  We won’t be fooled again.

Unfortunately, the “we” in that last issue complicates everything.  Everyone seems to be waiting for a correction.  You know what happens to the market when everyone knows something will happen?  The market absorbs that information into the price.  I’m no finance expert, but if we’re all sitting around waiting for a market correction, I don’t believe it will ever happen.  It’s like trying to convince a girl to date you.  The least likely way to make it happen is talk about it.  If we want the markets to go down, we have to go out there and do something really stupid.  We can’t just expect it to happen. I digress. Moving on…

From http://online.wsj.com/mdc/public/page/2_3021-peyield.html

From http://online.wsj.com/mdc/public/page/2_3021-peyield.html

Interestingly enough, P/E ratios for the S&P 500 are not that high.  18.50?  Meh.  The Russell 2000 seems high, which may signal hard times for small-caps, but the large-cap S&P doesn’t seem that overpriced.

So what to make of it? I will tell you my most honest answer:  I have no idea, but since every article title on Yahoo Finance goes something like “How I Learn to Love and Stop Fearing the Eventual Correction that Will Happen Any Day Now”, I wouldn’t be surprised if the large-cap S&P did the opposite of expectations and continued a cycle of small ups and downs. Maybe we’ll experience a small-cap crash that won’t affect the most commonly followed indexes?  Who knows.  See you tomorrow S&P.

Disclaimer: This blog is not intended to be investing advice.  In fact I would highly suggest not using anything I say as investing advice since I know next to nothing and I do not want to be sued.  If you use anything I say as investing advice and then you’re the only one liable because I have no money to take and you really are not that bright.  I’m not sure if this is legally binding, but I want to write about the markets without the threat of being sued.  So don’t sue me.  Please.

What I’ve Learned After 2 Weeks of Learning Python

Most helpful book I’ve found so far.

If you read my previous post, you know I’m brand new to coding.  I had some previous experience with HTML and CSS (which I use constantly at my current job), but I’ve never learned a tried and true programming language.

Conventional wisdom (i.e., blog posts I didn’t bookmark) states that beginners should start with Python,  so I picked up a few books and dove head first into the world of programming languages.

Two weeks later here’s what I’ve learned:

  • Coding seems so insurmountable to the noob because coding has a ton, and I mean a TON, of jargon.  Every element seemingly has a different name.  Learning jargon takes time as well, which might be another reason why coding or programming seems like magic to the technophobe.  The most intimidating factor of traveling to other countries is the language barrier.  The computer world is no different.
  • Usually the people who make the worst teachers are the ones who never struggled at learning something.  The coding world is seemingly comprised of people who never struggled at learning how to code. You might find this presumptuous, but I’m currently using two “Beginning Level Python Books” and the authors gloss over so many important factors that should be explained thoroughly to the beginner.  In one book, instead of explaining what exactly a sentry variable does for a while loop, the author simply states that sentry variables are important.  I had to figure out on my own that they, at least from what I understand,  initiate while loops because the loop picks up the variable, sees the variable as false, and starts the loop.  I could be wrong about this, but how would I know?
  • Sometimes the syntax doesn’t make logical sense, and rewiring your brain to speak the language takes time.  For example, look at the bastardized code below:
def derp():   print("hurrr derp")

this_is_terrible_coding = derp()
  • Since I’ve already established the function of derp(), I would expect derp() to be on the left side of the equal sign since I, as an English speaker, read left to right.  However, in order to assign a function to a variable, you must put the variable (what you don’t know) on the left and put what you already know on the right.  Although I know this is something extremely simple to grasp, it rubs against my preconceived notion of how to read, so it takes some time to burn that into your brain.
  • Most importantly, coding is not magic.  What do I mean by this? To those who know little about technology, a skilled programmer magically sits at his or her computer and somehow prevents a bored precocious college student from hacking into the system and destroying the fate of the free world (or at the least a company’s bottom line) or a skilled programmers spends  a few weeks creating something like “Flappy Bird” which makes the skilled programmer so much money in a few weeks that the person retires to the Hamptons.  Most people hear about these scenarios quite frequently, but most people have no understanding how these scenarios happen. However, people know the results of these scenarios are very real.  The inability to explain how these things happen coupled with the very tangible consequences gives coding or programming (or IT in general) an almost magical aura, which I think leads to a notion that someone not coding or programming from age two shouldn’t bother trying to learn because they don’t have the talent (like Muggles in Harry Potter). Of course, some people have the innate talent to learn the IT arts, but that doesn’t mean the non-techno plebeian should resign themselves to a life-time of ignorance.

Whoa.  I intended for this post to be a few paragraphs long.  What do you think?

 

 

Dr. Python or How I Learned to Stop Worrying and Love Coding

Why is there a mouse on the cover? With apologies to Stanley Kubrick

Look at the list below.

http://money.usnews.com/careers/best-jobs/rankings/the-100-best-jobs

Glance at the list for a few seconds and you’ll notice one major thing:

  1. The best jobs are either medical or computer related.

In fact, you have to get to #15 before you find a job that’s not strictly computer science or medical related, and even that job–Market Research Analyst–relies heavily on statistics.

Our society has become so efficient that the only growing careers are the ones that sustain efficiency and medicine. For the longest time I tended to ignore this fact.  “Eventually,” I would say to myself “I’ll find something to pursue as a career that’s not technical, pays well, and is stable.”

Guess what?  Those jobs don’t exist anymore. In a year I will probably be following my girlfriend to the other side of the country to, once again, begin a new career.  I have one goal for that job search: spend very little time looking for a job.  In my most recent job search, I worked my tail off for nine months to try to find a job in library science (lololol).  Of course that didn’t work out, so when I start the whole dog-and-pony-show that is job searching again, I want to be in demand.  It’s an enormous goal.  Very few, and I mean very few, people are in demand these days.  It doesn’t happen.  Most of us have become expendable whether we like it or not.

So I decided, with the knowledge that unemployment for software developers is an incredible 2.8%, that I needed to learn how to code. I know very little about coding, but I love to learn, and I also love a challenge, so I invested $5 in the 4th Edition of O’Reilly’s Learning Python (since Python seems to be the best place to start for beginners).   We’ll see how long this lasts, but I don’t see my desire to learn dying down anytime soon.

What do you think?  Is this a good idea?  I often read comments trying to discourage noobs from learning, but I know I have the chops, it will just take time and dedication.

 

Unlocking the Power of the P/E Ratio

Ahh.  The P/E ratio.  Possibly the easiest thing to understand in the history of stocks and bonds.

It also tells you virtually nothing, but I’ll save that for later.

The P/E ratio stands for Price/Earnings or the price of one share of stock divided by per share earnings.  Some people call the wonderful ratio the “earnings multiplier” in order to make something very simple a little more confusing.

Let’s take, for example, one of my favorite stocks Amazon (AMZN) (numbers via Yahoo Finance):

amazon numbers

Amazon has an absurdly high P/E ratio (the average is 20).  So what does an outrageously high P/E ratio mean?  A high P/E ratio means that for every one dollar Amazon earns (outside the stock market) the market is willing to pay $609.80 for a share of stock.  In other words, almost everyone feels that Amazon has a potential to earn a lot more money some day in the future, but right now Amazon  earns very little compared to how much the market thinks they should earn.

Generally you want a low P/E ratio when purchasing stocks (compared to similar companies).  If a company (Tom’s Widgets for example) has a P/E ratio of 2, that means the company’s earnings per share is HALF of what the market thinks one share of the stock is worth. If the low P/E is genuine, then people are underpaying for the price of Tom’s Widgets because the price of the stock doesn’t reflect everything  Tom’s Widget owns (e.g., plants, widgets, inventory, the CEO’s Bentley, etc.).  Of course, you must approach low numbers with a sense of caution. Although a low P/E means the market undervalues the company, a low P/E could also mean the company will soon declare bankruptcy.

Like every other measure in finance, if you take the P/E ratio on its own it tells you next to nothing.  Enron once had a pretty healthy P/E of 50.  That did not end well.  Also, the trailing P/E only reflects what the company earned in the past, not what the company will earn in the future (no one knows that).  If you know for a fact what company’s will earn in the future, you really shouldn’t be reading this post.

 

And the winner is!…Not You: Cable Company Rant

A couple of days ago, it was announced that on Sunday night the Oscars would be streamed live, for the first time, on the internet.*

*I include the asterisk because we both know that the Oscars have been streaming live, illegally, for probably close to a decade.  So what the announcement actually states was that people in charge of the ceremony, and ABC, would finally earn some profit from streaming the ceremony on the internet**

**I have to include the second asterisk because cable networks and cable companies have managed to deny all common sense again by only allowing those with cable subscriptions to view the ceremony online.  Yes.  This caveat surprises no one, cable networks have (except for CBS) been making boneheaded decisions like this for years; however, this particular boneheaded decision raises many valid points.

For one, if cable companies refuse to open up the ceremony to everyone on earth, then one must conclude that revenue raised from cable subscriptions on a whole greatly outweighs the ad revenue the cable companies would earn if they opened up all of their programming to the world via the internet. I could be wrong about this, but I know how much companies love making money, and if a company could make more money via live streaming to everyone, they would. But heck, cable companies are hardly trying to test the market.  You know why?

Because they know the second they offer one big event via streaming people will flood cable company customer service centers with cancellation calls.  The traditional cable subscription is already on the razor’s edge of oblivion. However, although the cable companies seem to know this, they also seem to believe that they can delay the inevitable by refusing to innovate.  Which, let me tell you, always works out well for the company (sarcasm).  I don’t know what the catalyst will be (my guess is 90% of quality programming being created by companies like Netflix), but it will happen sooner rather than later.

And I can’t wait.

Comcast and Time Warner Cable Merger

2014-02-12 22.20.06

This is a (very horrible) picture of my TV.  Why do I show you a picture of my TV?  Because my TV is celebrating the recent Time Warner Cable and Comcast merger the best way it knows how: by not having a cable hookup.  None.  Nada.  I use it to watch DVDs and that’s about it.

I’m not the only one without cable.  Almost every single one of my friends has no cable subscription.  I can only give you one friend who subscribes to cable.  The rest?  They’re perfectly fine watching their favorite shows on the internet, whether legally or illegally.

It was just announced that Comcast is purchasing Time Warner Cable for $158.82 dollars a share.  My initial reaction?  How much revenue does Comcast gain from cable packages?  I obviously don’t know much about the two companies, but I got a feeling the majority of Comcast revenue comes from providing cable to their somewhat unhappy customers.

The current generation doesn’t purchase cable and they never will.   While that may not be evident to huge conglomerates right now, it will in ten years when subscription rates drop drastically.  If cable companies rely on cable packages for revenue and if they don’t see how the times are changing, then I think we could see a huge problem for cable companies in five or six years.  I understand that previous statement contained a lot of “ifs”, but I don’t have much faith in the 1,000 pound gorilla (now 1,500 pounds) seeing a need to change any time soon.

 

Why Should Apple Buy Back (Repurchase) Stock?

2014-02-11 21.23.17

An Apple

By now, you’ve probably seen a news article about Carl Icahn’s quest to convince the Apple board to repurchase shares outstanding of its stock.

Apparently, Icahn feels (or felt) that Apple needed slim down the $14,000,000 in cash hanging out on its balance sheet.  Most companies will do that by purchasing stock.

If you’re like me, you’re probably wondering: “Why in the sam-hill would a company want to repurchase its own stock?”

You know what?  That’s a very good question.  To the lay person repurchasing stock seems counter-intuitive.  Why repurchase something that you sold in the first place?  Won’t a company lose some of the money that you already have sitting in the bank?

Like I said, very good questions.

But I hope to give you some very good answers to those questions (in no particular order):

  1. Repurchasing stock increases earnings-per-share (EPS)
  2. Repurchasing stock theoretically increases the demand for the company’s shares (since there are is less shares to go around)
  3. Repurchasing stock gives companies something to do with extra cash since cash does nothing just sitting on a balance sheet (except for increasing the company’s liquidity or their ability to pay bills)*
  4. Repurchasing stock shows the public that the company’s leadership believes its stock is undervalued (since they’re buying them at a reduced price).

So basically, you have a board of directors who own a TON of stock in a company they direct.  They feel that the price of the stock is currently undervalued.  If they repurchase shares, they’re basically buying the ownership of their company back at a reduced rate.  When the the price of a company’s shares go back up, less shares outstanding makes the cost of the shares increase even more than what they would have increased before the repurchase (in theory).

So that, in a nutshell, is a very basic explanation for why a company would want to repurchase its shares.  Basically, it has to do with money (not surprisingly).

*Cash is an amazing thing for people, like me, who have never had it.  For company’s and people who have lots of cash, it’s a curse.  Why?  Because cash does absolutely nothing to make more money;  it just sits there.  For example, let’s say that you work fifty hours a week to pay rent, and you have a dead-beat roommate who doesn’t pay rent and sits all day on the couch playing video games.  For rich people and companies, cash is the roommate because it could be out finding a job and earning money.  “BUT” I hear you say “What happens when the company hits dire straights? Don’t they need to pay their bills?”  They do, but you have other options, such as other stocks, that actually make money that you can cash out quickly when crap hits the fan.