Stock Prices Don't Mean Sh*t... Here's Why

Good news is bad news… but not this time around

When economic updates are too good, they have often been coupled with rising concerns that the good news means a longer wait until the Fed rolls out more rate cuts.

This past week was different.

Inflation gauges showed prices had cooled more than expected.

American financial outlooks were better than they have been in years.

Inflation expectations fell and on Friday, U.S. import prices reversed and dropped sharply, adding more fuel to the disinflationary fire.

Are we on track to move closer to the Fed’s 2% target?

Only time will tell, but its looking more promising.

Stock Prices Don’t Mean Shit Anything.

New investors like to place a high emphasis on stock prices and for no reason at all.

Oscar Wilde once said:

"A fool is someone who knows the price of everything and the value of nothing"

And Oscar was damn right.

A $20 stock can be expensive.

A $500 stock can be cheap.

If that made no sense to you, let me explain…

Back to the Basics

I’m a big believer in the Price-to-Earnings (P/E) ratio because it contains useful information in just one number.

The price of a stock represents how the market values a company. It's the average of thousands of investors' subjective opinions.

The earnings, however, are objective. How much money did the company earn this past quarter? It's a plain fact.

Therefore by that logic, the P/E ratio compares investors’ collective opinions against what we would call “the actual truth” of a companies earnings.

How does it work?

A P/E ratio of 20 means that investors will pay $20 today for $1 of current earnings.

Why would you ever trade a $20 bill for a $1 bill? That’s terrible deal… right?

Well, it’s not all that bad.

Because stock prices are a forward looking indicator, meaning that earnings are priced into the market based on future projections, a higher price means that investors will expect more than $1 of earnings to roll in over the coming years.

A higher P/E ratio can be a sign of bullishness.

Why?

Investors are paying a premium for the stock because they expect significant growth in the future.

Meanwhile, a low P/E can be a sign of pessimism.

Why?

Because it can suggest that investors are not confident in the companies future growth.

Comparing P/E Ratios

A common mistake investors make is using the P/E ratio as a means to value stocks in different industries.

The P/E ratio should only be used to value stocks within the same industry and market.

Different sectors have varying growth rates and market conditions, which will have a large impact on their P/E ratios.

For example, technology companies often have a higher P/E ratio because of their rapid growth potential.

The average P/E ratio in the tech industry is ~35 in Q1 2024.

While the average P/E ratio across the S&P 500 index is ~28 (as of time of writing).

If the P/E ratio is the compass that helps direct you when you don’t know which direction to go in, then the Price-to-Earnings Growth (PEG) ratio is the GPS that will tell you the exact route to your destination.

The PEG ratio takes a companies P/E ratio but with their forecasted growth rate based on its previous earnings report.

Not only does it tell you the valuation of a company today, but it will give you a better idea of where it’s headed in the future.

The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings and using that as an estimate going forward.

It’s essentially saying that this company has grown by X in the last year and we will use that as a benchmark to project in future years.

With the PEG ratio, the lower the number, the better deal you’re getting.

When comparing two stocks, looking at their PEG ratios can tell you how much you’re paying for growth in each case.

A PEG ratio of 1 means you’re breaking even as long as the company continues to grow.

A PEG ratio of 2 means you’re paying 2x as much for projected growth over a stock with a PEG of 1.

What not do to do…

Solely relying on both these ratios to make investment decisions.

It’s always a wise to use these ratios as a comparison metric between companies in the same industry.

They also do not account for things like a companies management, moat, industry trends, or economic impacts.

Factor that into your decision when making new investments.

P/E Ratio’s by Sector

The image below gives a good overview of current P/E ratios by sector.

As you can see, Information Technology is leading the way at 35.04, which is considered expensive based on it’s 5, 10 and 20 year trends.

The lowest P/E ratio is within Energy at 13.27, considered a fair valuation based on past trends.

What’s interesting to see is that Real Estate is currently undervalued based on it’s current P/E ratio across the board.

It’s an industry I’ve been buying heavily in and as rates continue to come down, the Real Estate industry will only benefit as it’s largely dependent on debt financing for their projects.

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