Imagine having the secret to Warren Buffett’s success – the one trick that has made him one of the world’s richest people.
Well, it’s no secret. Mr. Buffett – and many of the world’s most successful value investors – rely on a simple formula to determine if a stock is trading higher than it’s really worth, or at a bargain.
The formula is the price-to-earnings (P/E) ratio and it strips a stock down to its basic fundamentals - earnings. All good companies have the potential for strong and consistent earnings that grow over time. The P/E ratio ties the trading price of the stock to those earnings. The price of a stock indicates the market’s expectation for earnings.
It comes down to simple math: the price of a stock divided by the company’s earnings per share. Earnings per share is determined by the outstanding number of common shares divided by earnings.
As an example, a stock that trades at $10 and has earnings per share of $1 is trading at 10 times earnings.
A trailing P/E uses past earnings and a forward P/E uses future earnings estimates. Some investors use a blend of both.
However, the P/E ratio doesn't tell the whole story by itself. It's usually more useful to compare the P/E ratio of one company to other companies in the same industry, to the market in general or against the company's own historical P/E.
Here are few examples of P/E ratios as of Friday’s close:
- S&P 500 trailing: 21.6x
- TSX trailing: 21.6x
- TD Bank: 13.1x/12.2x
- Netflix: 207x/150x
Notice how TD Bank’s P/E ratio is much lower than Netflix. Investor believe a relative upstart like Netflix has more potential for earnings growth than a mature company like TD Bank.
One thing to keep in mind: The quality of the P/E ratio is only as good as the quality of the underlying earnings number. The P/E ratio doesn’t work if the earnings aren’t credible.