Dumb Question # 2: Widget's P/E

[zyzzyva57]

Why wouldn't I like a low P/E in as much the foundation of the P/E is the EPS; that is, shouldn't I like the highest possible Earnings per Share? Isn't juicing up the EPS one of the reasons for Widget, Inc. to buy back its shares--ergo, in the process, lowering its P/E? Why even screen-to-buy companies with a high P/E as a positive metric as opposed to a negative metric?

[David Briggs]

EPS reflects earnings of today or recently. Earnings growth reflects where earnings could be in the future. Rate of earnings growth reflects how soon earnings might get to the projected target.

The marketplace is willing to pay a premium for accelerated earnings growth. So higher P/E stocks might actually be a bargain. You need to dig deeper into the source of revenues, the ability to control costs, and the dynamic of future profitability.

[zyzzyva57]

I am still missing it

Two companies are the Best of Breed, so why wouldn't I want the one with the most Earnings and therefore a lower P/E

Isn't jacking up Earnings one of the reasons a company does a buy back? Wouldn't its P/E go down as it bought back shares? In theory, wouldn't the share price be worth steadily more even if Wall Street disagreed with what it would pay for a share? Isn't this the foundation of a Value Investor: buying stock in a company Wall Street was failing to see the value?

[David Briggs]

First, higher earnings don't automatically equate to lower P/E. The two stocks you are comparing would need to have the same number of shares for that to be true.

Second, two so-called "best-of-breed" stocks would typically be in two different industries. (Otherwise, one of them would by definition be "second best"). Different industries often experience different P/E ratios just due to the willingness of the marketplace to pay more for the prospects of the future of one industry over another.

Third, I agree that buying back shares reduces the P/E multiple of a company even if its earnings stay flat. But it also means that growing its business is NOT the best use of capital that the company can think of. What does that say about management and the future of the business?

Here is a value investing article you might enjoy:

http://www.fool.com/news/commentary/2004/commentary04080902.htm

[zyzzyva57]

(1) You are, of course, quite correct about Best of Breed--bad error on my part

(2) In Master Cramer's book he shills all the time, he compares Maytag and Whirlpool, which at the time the book was written was a good comparison, and I saw his point until I blinked and things got fuzzy on the P/E being such a big deal if Earnings are so important...

(3) I apologize for belaboring the point, but it still seems to me a low P/E allows me to buy Earnings cheaply, to wit:

Widget earns $20 and has 10 shares outstanding, and thus its EPS is $2 per share...With 5 shares, the EPS would be $4

With a price of $20 per share, the P/E in instance one would be 20/2 = 10 and in the second instance 20/4 = 5, yet for some reason I am missing, the first instance in general is better than the second!

I realize also the P/E is a very, very relative term and standing alone it means nothing really

Does my confusion make any sense? I do want to get a grip on this most important metric...

[David Briggs]

2 entries found for shill.
verb transitive
1. To act as a shill for (a deceitful enterprise).
2. To lure (a person) into a swindle.

Sometimes Cramer is wrong, but honestly and sincerely so. He certainly knows the power he has to influence trading, and I presume complies with all regulatory requirements which prevent him from benefiting from price movements resulting from his own recommendations.

I'm not sure where your citation comes from that a higher P/E is more favorable than a lower P/E ("the first instance in general is better than the second.") I can see where you would feel confused if that is your take-away from something you've read or heard from Jim Cramer.

Yes, lower P/E implies better value. On the face of it, you are buying more with less. However, now you need to ask yourself why the marketplace has allowed such a "bargain" to exist. Perhaps price is depressed because earnings are expected to stagnate or decline!

The firmest grasp which you have already attained with regard to the P/E metric is that it is just one of many. You already know from the Whirlpool / Maytag comparison that data goes stale, and that all the study in the world can never turn a snapshot into a movie.

[NATHAN LLOYD]

Third, I agree that buying back shares reduces the P/E multiple of a company even if its earnings stay flat. But it also means that growing its business is NOT the best use of capital that the company can think of. What does that say about management and the future of the business?


That is a really good point. I never thought of it this way.

The same goes for dividends right. I mean I'd rather a company believe in investing in itself than investing in the shareholder. I'd like to think the company I'm investing in can use money better to make their company grow than to invest in me.

Why do dividends get a lot of hype?

[NATHAN LLOYD]

PEG is much more important than the P/E because it takes into account expected growth rate.

P/E only takes into account the present, and can get you burned...I've learned this from experience.

You can, however, compare this years P/E to next years. If next years P/E is lower than this year, this means the company is expected to have higher earnings the next year than this year.

[David Briggs]

Yes similar message from dividends, but many dividend-paying companies have dividend reinvestment programs. That way, they can make distributions and still put them to work! Now that's what I call stewardship.

[zyzzyva57]

The section of Master Cramer's book on Whirlpool/Maytag could have more tightly written, because it is the best section for me, but I have a hard time following it...He explains why one company is a better bargin at higher stock price, and I think in the book he does P/E this way: Momentum = P divided by E...I had wondered what was the "x" to P/E as the "M" of P/E

The term "shill" was inappropriate, and I honestly apologize to my Master for using term "shill" instead of "puff," for I firmly believe he or members of his staff visits with us here...For example, a few months back, we got our panties in a wad that something had to be afoot with insider trading on his shows--we were forming a lynch mob to turn him over to the SEC and then for a month or so, Master Cramer almost nightly addressed this after hour trading you see on the scrawl below his show...Even now, he often warns us Newbies of the dangers of engaging in this...Back when the lynch mob was forming, I often warned logic seemly did not lead to our Master having to engage in insider trading tom-foolery...Hell, Master Cramer had too much to lose...To make a profit to justify insider trading by him would set off all kinds of alarms with the SEC and worse, his multitude of enemies on the street who parse his every word and deed, because of their "Cramer Envy"

I find it refreshing to see him screw up just like I do, but the key is he still wins more times than he loses...The real Cramer is good and it is nice learning some of the Secrets of the Wall Street Temple!

[optimus25]

Why do dividends get a lot of hype?

Because its a safe bet. Cash rich companies that can pay out dividends will do okay in any type of market. Dividend payers are for long term investors who don't really follow the market as closely as we do on this forum.

Case in point; Bank of America, if you include the returns from dividends, you get like an annualized 15% return the past 15 years. I'll take an annualized 15% return for 15 years any day. And if you did some market timing when the stock took a hit in the late 90's you'd probably return 20-25% annualized w/ the dividend.

[optimus25]

After reading "Super Money", I question how companies report earnings. There are a lot of things going on with a company earnings that we can't understand unless we are CFA's or MBA's in finance. How does a normal lay person understand what's going on with a company's financial statements...what I hear from my CPA friends are that the details are in the footnotes.

High PE, High Growth Rates, High estimated EPS...there are so many metrics to compare to find a growth stock.