The numbers below are crucial to learn for anybody new to investing. In fact, we strongly discourage investing in individual stocks until you have a good grasp on each of these numbers. We’ll be using a lemonade stand to help explain each term.
We put together a Quick Accounting Lesson just in case you have any questions about the accounting terms we’re using (such as Book Value), please reference this if you have any questions.
- Market Cap – This is the total value of a company’s common equity, or the value of all the shares outstanding.
- If you have 100 shares of stock in your lemonade stand, and each stock is worth $20. Your lemonade stand’s market cap is $2,000
- Price to Earnings (P/E) Ratio – The price of a share of stock compared to the last 12 months of profit per share. This is the premium the market is willing to pay on your earnings – the higher the P/E Ratio, the more of a premium the market is paying on your earnings.
- If your net income last year was $1,000, and there are 100 shares, each share made $10
- Thus, your P/E Ratio would be the price, $20, divided by $10, which is 2.0
- Forward P/E Ratio – The price of a share of stock compared to the next 12 months of profit per share. This should be given more weight than the P/E Ratio, since this is the expected profit that the market is currently paying for.
- If analysts expect your stand to make $1,500 next year, thus each share earning $15
- Your Forward P/E Ratio would be $15/$10, or 1.5
- Price to Book (P/B) Ratio – The price of a share compared to the amount of assets available to shareholders.
- In the Accounting Primer, our Lemonade Stand has a Book Value (or Owner’s Equity) of $1,000.
- Thus, the Price to Book will be the Market Cap divided by the Book Value
- P/B = $2,000/$1,000 = 2.0
In general, we invest in companies that are undervalued:
- Low Valuation Relative to Market Opportunity
- Does this specific company have the potential to takeover an entire industry (such as Amazon in retail), or does this industry have incredible growth potential (such as search engines and Google)?
- These calls are admittedly more risky, nobody has a crystal ball. With that said, the payoffs are monumental if you’re right, and we’ll justify why we believe our investment choices have this potential.
- Low Forward P/E Ratios
- Low forward P/E ratios relative to the market (which we benchmark against the S&P 500) typically indicates that the market believes this company or industry is declining – we dig through these investments and look for mismatches between low valued securities and their future potential.
- Low Price to Book Ratios
- If the company was liquidated tomorrow, what would shareholders be left with? When Price to Book ratios are below 1.0, that means shareholders would receive an immediate benefit if the company was liquidated. This shows what the “floor” of an investment would be.