my son has been successfullysubdued, so i think this is a good time to learn about theprice to earnings ratio. and a lot of times you'llhear people talk about a stock's p/e ratio. and it's all the same thing.
apple stock close price, it's just a fasterway of saying price to earnings ratio. so let's think about the priceto earnings ratio of the company in question, this widgetcase study, i guess you
could call it, that we'vebeen dealing with. let's say that the marketvalue-- we talked before that the book value per shareof this company is $5. because the book value of itsequity is $5 million. and there's 1 million shares. so 5 million dividedby 1 million is $5. but let's say that the marketprice, let's say that this is widgets inc. and let's saythat its ticker symbol is winc, for widgets inc. and itsprice is, it's trading at--
let me make up a goodnumber-- let's say it's trading at $3.50. and then we learned in the firstvideo that a price by itself doesn't tellus a whole lot. so how may shares are there? we know there's amillion shares. so the market cap, or what themarket perceives the value of this equity is, the marketcapitalization, is these two numbers.
if we have a million shares,then each of them, the market is saying, is worth $3.50, thenthe equity of the company is worth $3.5 million. and this is the market value ofthe equity, what the market thinks the equity's worth. so this is interesting. in our case, the book value ofthe equity was $5 million. but the market is saying, no,no, i don't necessarily believe those accountants.
maybe they're throwing somestuff in here that's not really there. so we say it's only worth$3.5 million. in this case, the company'strading at a discount to its book value. and i won't go into detail onthat now, but that's actually a fairly unusual circumstance,unless people are very suspicious about the accountingor the actual book value of the company.
or if they think that this isjust a kind of an asset with a useful life that hasbeen shortened. if you owned a bunch of videostores, then all of a sudden you say, i have $10 million ofvideo stores, and then the next day someone makes on-demandvideos there, all of a sudden, maybe your assetsaren't worth what you thought they were before. but we'll talk a lot more aboutthat when we deal with real examples.
but in this case our market capis below our book value. and you can even look atit from the price. i said the price doesn'ttell you much. but it tells you a decentbit if you think of things in per-share. because we know that the bookvalue per share is $5. the price per share, the marketprice per share, is $3.50, so you could alsosay it's trading at a discount to book.
now, what were the earningsof the company? well it was making $0.35. so let me write this down. earnings was $350,000 in 2008. and let's just say we're lookingthis from the vantage point that 2008 has happened. this isn't like i'm at the beginning of 2008 and modeling. so let's say we're looking atthis on january 1, 2009.
and let's say the company hasalready released its earnings, although it normallytakes a lot longer. probably closer to45 to 90 days. but let's say they releasedtheir earnings. so we say, oh this companymade $350,000 in 2008. or another thing that you mightsee a lot when you look at companies, is that this istrailing 12 months earnings. you'll see this ttm sometimes. because when someone saysearnings, are those the
earnings last year? are those the earningsthat you're predicting for next year? so this is trailing 12months earnings. and if you want to look atearnings per share, eps, is this number divided by thenumber of shares was $0.35. so first, just to learn whatthe price to earnings ratio is, let's just calculate it. then we can talk about what itactually means and if we have
time, we can have a discussionon why a company might have a higher or lower priceto earnings ratio. and that discussion can actuallyget quite involved. but in this case, you literallyjust take the price of the stock and you divide itby the earnings per share. so let me switch colors justto ease the monotony. the price to earnings ratiois equal to the price-- so $3.50-- divided by theearnings per share. divided by $0.35.
so in this case, the priceto earnings ratio is 10. what does that tell you? well there's a couple ofways to think about it. one is, you could kindof flip this. no-one ever talks about theearnings to price ratio, but that's an interesting thingto even think about. because it connects it witha lot of other financial concepts that are out there. so this is kind of a sal specialratio, but it's a
useful one to think about. the earnings to price ratio isjust the inverse of this. 0.35:3.50, which isequal to 1/10. or 10%. and so the way to think aboutit is if you're paying $3.50 per share for this company, andlet's say the company next year-- so this is trailing12 months earnings. but let's say this company, forwhatever reason, it's a really stable company.
it's doing the samething every year. it's not growing. it's not shrinking. let's say that not only is thisthe trailing 12 months earnings, but this is also--actually, i'll introduce terminology right here. so this is trailing 12 months. you could also haveforward earnings. what are forward earnings?
you can probably guess. the earnings i just said, thisis actually what happened to the company. this was the earnings ofthe company last year, or the last 12 months. forward earnings are, you know,there's a bunch of guys with mbas and cfas working forthe banks, and they write research reports. and they model the company.
they meet with the company. they analyze the industry. and if they're good analysts,they'll come up with a number. they'll say, i thinkthis company is not going to change. it's such a superstable business. they're going to make $0.35in 2009 as well. so in this case, this wouldbe the forward earnings. and usually if it's awell-followed company, there
might be 10 or 15or 20 analysts. and what they do is they averageout all of the numbers from all of those analysts. and then if the average is,let's say, $0.35, they'll call this the consensus. so the consensus is just theaverage of all of the sell side analysts out there. and maybe i should do a wholevideo on what sell side means, but since i said the wordi'll tell you right now.
sell side are like theinvestment banks and the research houses. and the reason why they're thesell side is because they're always selling you stuff. they're selling you stocks. they're brokeringtransactions. they write these researchreports because they want to go to institutional investorsor people who have their brokerage accounts with thesebanks, and essentially sell
them stock. say hey, you should buy widgetsinc, because it's only trading at a price toearnings of 10. and we really like it. it's much better than buyingtreasury bonds right now, because you're makingmore money on it. you're making 10%, and that'sjust to connect the dots. price to earnings of 10. if it's stable, you're makingthe equity will grow in this
coming year by 10%. and that's better than what youget out of treasury bonds. so that's what sellside means. so a sell side analystis someone who publishes these reports. a buy side analyst is someonewho works for a hedge fund or works for fidelityat a mutual fund. or works for an endowmentor a pension someplace. and they're managing otherpeople's money.
and they're trying to figureout if they can believe what's happening. so they're going to dotheir own analysis. so that's what thebuy side is. those are the people who areactually managing money and deciding what they want toinvest the money in. the sell side are the people whodo analysis and say, hey due to my analysis isn'tthis a good stock? don't you want to buyor sell this stock?
so fair enough. that was a bit of a diversion. anyway, going back to price toearnings, we calculated the price to earnings. it was 10. but the reason i wanted do toearnings to price is because it connects it back to thingslike yield and interest. i can do a price to earningson my bank account. let's say in my bank accounti have $100.
so this is a diversionright here. so let's say i have $100in my bank account. and over a year i make 2%interest. let's say it's guaranteed 2%. maybe it's in the cd. so i have $102 at theend of the year. this 2% were my earnings. so i made $2 of earnings. so the way to think about a bankaccount is, well how much
do i pay for thatbank account? well in this case i paid $100for the bank account. so the price would be $100. and the earnings on thebank account in that year were $200. so it has a price toearnings of 50. or if you do the earningsto price, if you do $2/$100, you get 2%. which is normally how we thinkabout bank accounts.
we say, oh i'm making 2%interest on that bank account. now, this actually leads to avery interesting question. if a bank account only givesme 2% on my money, and this company is arguably giving me--assuming that it's stable and i believe the consensus--it's giving me 10% on the money, why would i even holdthis bank account? why wouldn't i just pourall of my money? why am i willing to pay a higherprice to earnings for the bank account than iam for this company?
and i think you already get thesense that the lower the price to earnings, all elseequal-- and that's a big thing-- all else equal, thelower the price to earnings, you're paying lessfor something. you want to have a lowerprice to earnings ratio for the same asset. because you're getting the same earnings for a lower price. but when you lower the price toearnings you are increasing
the earnings to price. so you would increaseyour yield. you want to maximizethis number. but i'll finish this video withkind of a basic question. why would someone ever keeptheir money in the bank at 2% or a price to earnings of 50,when they could have a price to earnings of 10 withwidgets inc.? and the answer is becausethis is very uncertain. who knows what happenswith widgets inc.?
maybe all of these guyswere-- maybe this is a big ponzi scheme. i mean, most companies inthis country aren't. and that's another thing to talkabout, is country risk. because even though you'reprobably suspicious of them now, the us has some of themost transparent companies with some of the best accountingstandards. if this was in-- you know,i don't want to state any countries because people allover the world listen to these
videos-- but if it were acountry with less solid accounting standards, you wouldbe like, they might be making up all of their numbersso i don't trust it. or you might say, you know,widgets inc., even though the analysts are saying that they'regoing to make $0.35 this coming year, you mightsay, you know, i don't believe that. i think there's actually a lotof risk in widgets inc. that there's actually more volatilityhere than anyone
gives credit for. they might go out of business. there's a strong competitor. there's a lot ofrisk involved. and the other thing is,even if you don't think there's risk. even if you think that thiscompany's going to make $0.35 forever, the other reason whyyou might prefer to have a bank account over widgets inc.is because you're guaranteed
to get $102 back for your bankaccount at the end of the year if you wanted. assuming this is a cd witha one year duration. you're guaranteed to get your$102 back, especially if it's fdic insured. but in this case, even thoughthe earnings might be the same, something horrible mighthappen to the markets and everyone just dumps theirstocks, money flows just run outside of markets.
and for whatever reason peopleget scared, and the price could go down a lotfrom $3.50. it could be very,very volatile. and this thing, maybe the pricegoes from $3.50 to $1.75 a year later. which it seems like a reallygood deal, because now the price to earnings is $1.75divided by $0.35, would now be a 5 price to earnings. but this could happen.
i mean, companies go from a 10to a 5 price to earnings. and then all of a sudden, ifyou want that money, if you need that money a year later,you've lost half of it. so there's some volatility inthe price even though you're assuming that the earningsare stable. so that's a little bit of ataste of why someone might realistically, in this case, paya higher price to earnings for safety. safety because you know thatthis earnings stream is
guaranteed. and liquidity. liquidity because youknow you're going to get your money back. that you're going to be able toessentially sell your bank account and get cash for it. and you know that it'sgoing to be $100. that there's no volatilityin price. well in this case, you'reuncertain about
the earnings stream. you're uncertain about what themarket will be willing to value it at a year later. and frankly, you mightbe uncertain about liquidity in general. maybe this is a really smallcompany and not a lot of people trade in it. and you might not even be ableto find anyone to buy it a year later.
the epitome of an illiquidasset is maybe a really expensive $20 million house. even though it might be worth$20 million, a year later you might not-- there are only somany people who can afford a $20 million house. so it's an illiquid asset. anyway, i want toleave you there. in the next video we'll go intomore depth on price to earnings ratio, and think aboutthings like growth and
stability and whatnot.
