P/E And P/S Ratios
The Dynamic Wealth Report
April 30, 2008
Can P/E Lead To Gold?
As an investment banker I traveled extensively. I had the opportunity to
work in countries as diverse as Taiwan, Singapore, Great Britain, and
France just to name a few. During my travels I loved nothing more than
meeting people from those countries. While we may have spoken
different languages, the language of business was always
the same no matter the location.
I met many successful entrepreneurs and more fund managers than I can
remember.
But what I do remember are the extensive discussions about company
valuations. Not only what our business was worth but what others were as
well. A great debate always rose up when we started discussing similar
companies in different countries.
Not all valuations are the same.
What we discovered was somewhat unusual. A company on the German
DAX Exchange might have a greater value than a similar company on the London
Exchange or even the New York Stock Exchange.
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Obviously understanding this valuation dynamic is important.
I learned quickly that professional investors looked at companies all
over the world when determining the value of a particular company. And this information and
knowledge was . . . well . . . valuable. But, as the famous saying goes,
“value is in the eye of the beholder.” Nowhere is this more true than in
the stock market.
Let me give you an example . . . Airlines.
It’s no secret that I hate airlines. I think the industry is the worst
in existence. Companies can be crushed by any industry issue and
there are many issues: High fixed costs, extensive (but needed) government
regulation, high labor costs, and unpredictable revenues. And
don't even get me started on the constant price wars, aggressive competition,
and exposure to volatile commodities like oil and jet fuel. All together
these variables provide
a recipe for failure.
So why do I watch the airlines?
I hate the industry but I think a smart trader can make money trading
the airlines. One key to success is following the industry and monitoring the
ratios that
have some importance. For the airlines I’m going to focus on two key
ratios: Price to Earnings (P/E) and Price to Sales (P/S). You’ll see why
in a moment.
In the airline industry there are a number of major players.
United
(UAUA)American (AMR), Delta (DAL),
Northwest (NWA), and Southwest (LUV). I
know there are several others but let’s keep this simple.
As of right now, their ratios are:
United P/E – 54.1x P/S – 0.09x
American P/E – 21.8x P/S – 0.09x
Delta P/E – NA P/S – 0.17x
Northwest P/E – NA P/S – 0.19x
Southwest P/E – 17.1x P/S – 0.96x
Now don’t get flustered by these numbers. I pulled them right off
of Yahoo! Finance where anyone can go and find these financial ratios and many
more.
The first ratio I want to look at is Price to Sales (P/S).
The reason I started with this ratio is simple. I think it’s
meaningless. The average ratio in this group is .3x. and the range is
from .09x to .96x a difference of more than 10 times! Because the
airline industry brings in billions of dollars in sales, the ratio is
diluted. Delta’s ratio is almost double the United ratio . . . but what
does that mean? A change in these ratios ultimately won’t tell you much.
The key here is to make sure you use the right ratios and that the
numbers make sense.
The other ratio to look at is Price to Earnings (P/E).
When you look at these different airlines you’ll notice something
interesting. Every company has a different valuation and some have none
at all. As we know, P/E ratios compare a company’s stock price to its
earnings per share. If a stock doesn’t have a P/E ratio the
company doesn’t have
earnings. We all know that’s no good.
Look at United’s P/E ratio of 51.1x and Southwest’s ratio of 17.1x.
Knowing what you do about the industry, do you really think United
should be worth more than Southwest? Almost 3 times more? I mean really. Southwest consistently generates profits
year after year and United .
. . well, not so much.
Looking at these ratios I would conclude that United is overvalued and
Southwest is undervalued.
And this leads me to my final tip when using ratios.
Understanding the
“Why” behind the numbers is much more powerful than just noticing the differences. This is
where your due diligence and research come in handy. Over time you will
start to notice trends in the ratios. And it’s those trends that’ll help
you trade for profits in an otherwise horrible industry.
• Rice (Over $22 cwt)
How can I not mention rice futures. It’s all over the news. The
commodity is reaching new highs. Stores are limiting how much you can
buy. Some countries are limiting exports. Thailand, the largest rice
exporter on the globe said “There is no shortage of rice.” Hmmm .
. . something doesn’t jibe here.
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