Here I am reading my first book on the financial markets, writen by Robert Hashemian. I am currently in the section that talks about P/E ratio. That is the ratio between price of the stock and it’s earnings.
My understanding is that investing in the stock market is just like any other kind of investment, whether the investor forfeits present goods in return for future goods–with interest. And since capital flows between different investment options, until the rate of profitability is equalled among different investment options available, I suppose, the rate of return gained from investing in stocks should (ideally) equal the rate of profit in other investment options. My question is, if that’s the real case, why is it many companies pay so little dividends to their shareholders? I came to note this through the P/E ratios of companies. Some companies have P/E ratio like 75, meaning the price of the stock is 75 times the dividends the shareholder gets. That’s like lesser than .2 percent return on investment, no? Why do shareholders still buy the stocks of such companies? Is it all just to speculate alone?
Dividends are not the same as earnings (profit). A company can decide to pay out all profits as dividends, but it can also decide to invest all profits back into the business and pay zero dividends. P/E is only related to earnings (profit) and has nothing to do with dividends (i.e. the portion of profit paid out to shareholders).
A P/E is not the only way to value a business (company). A P/E of 75 could be because the company is growing rapidly (say, 50% a year growth) and depending on the probability of such growth being realized investors are paying a high price for the shares today in anticipation of the revenues (and profits) catching up in the future. Another scenario for paying a high P/E would be when there aren’t much earnings (profits) to speak of but the valuation of the company at such a price is much lower than the value of the assets (real estate, equipment, cash, etc.) owned by the company – or, the so called, Price-to-Book (P/B) ratio is low enough. As an extreme example, I could own a company that currently makes nothing (zero revenues, zero profits) but has a brand new Ferrari 458 (worth about $250k) as an asset on its books. How much thinking would you need if I offered to sell this company to you for $125k (At an infinite P/E, but at a compelling P/B ratio of 0.5)?
All investing, all action, and all life is speculation.
Dividend yields, which have been ignored for decades, are probably the truist measure of stock valuation. Dividends are portions of actual profits paid out by the company. Dividends yields fell out of favor back in the 1980s when investors started chasing growth and speculation. They were once the most important criteria when choosing stocks. I don’t like PE ratios. Companies can do all sorts of accounting gimmickry to fudge the bottom line. Also if a company is losing money, PE can’t be calculated. Likewise a company may had a huge one-time earnings, which will temporarily drive the PE to low levels, but not necessarily mean the stock is cheap.
There are actually two P/E ratios. There’s a backward-looking P/E and a forward looking P/E. The backward-looking P/E is easy to calculate but is useless to investors except to the extent that it helps them in forming an opinion on the forward-looking P/E. If I’m buying a stock today, I won’t participate in the earnings from last year or last quarter. I want to know what the earnings will be in the next year or next quarter.
The published forward-looking P/E is based on a consensus of analysts’ forecast of what earnings will be in the future. When those earnings finally do come out, they will “beat expectations”, be “in-line with expectations” or “fall below expectations.” The analysts’ consensus is often wrong, and there’s no way to know for sure if they are right or wrong, and if they are wrong in which direction, until earnings are actually reported. I might disagree with the consensus on earnings. If I think it is too low, I might buy the stock in order to take advantage of what I expect to be higher earnings at a bargain price. If I think it is high, I might short the stock. The point is that investors are interested in the unknowable future, not the past.