I get this question a lot. A LOT! It's understandable that I would though, because once you hear about the returns from the JSE and you decide that you want to invest in stocks the logical steps to follow are:
1. Get information on where to start. (Which you can right here )
2. Pick a Broker (There’s a great guide on picking a broker available here)
3 Take the money you were going to save and invest it instead (Here’s my thoughts on why you “shouldn’t save”)
Now at this point, you might realize “Damn…I don’t know what to buy…”, or you might have been chasing IPOs (really, really, bad idea guys, don’t do it) but didn’t get everything you wanted and trying to figure out what else you can put the money in.
Well, whatever you reason, I’m here to give you a simple primer on how to pick what companies to buy.
Now, the art of picking which company’s shares to invest your money in is exactly that, an art. Like any art, there is an element of science in it, but at the end of the day, it all comes down to a final analysis and guess (educated guess, but still a guess). It’s a guess that says “based on my thoughts/research/news/rumour/rake I believe that this company’s value will increase within a certain time period and increase enough for me to make a profit on my initial investment.”
There is a WHOLE LOT MORE that the experts can (and no doubt will) tell you that goes into investing, but I assure you, at the end of the day, it’s still a guess, and any broker/expert/”expert”/”investment advisor”/salesperson/insurance rep who tells you otherwise is very likely either trying to con you, or doesn’t actually understand investing in stocks. Of course you could happen to have an advisor who can actually see the future. In which case, go ahead and listen to them, and make sure they tell you the Super Lotto numbers too. Make sure they also throw in a free mask.
Now, I won’t go into my thoughts on the state of investment advice because in addition to pissing off a lot of people who are trying to con you out of your money via big words, nice sounding acronyms, a sharp suit and the illusion of safety/expertise, I’d also end up making this post much too long. So let me avoid that and jump right into the good stuff.
Now, a word of advice. “Experts” are likely to disagree with what I say here. I am going to be simplifying a lot of the process. I think it’s worth simplifying so anyone, especially those of us who get intimidated by investing, finance or just numbers in general can have a better understanding (even if it’s just a general one) of what goes into picking a stock. If you are looking for a comprehensive explanation of my personal methods, give up. This isn’t that. However if you want to know more about how the process is done in general (and maybe want to replicate it) then this will be right up your alley.
Now there is ONLY ONE technical term that I want you to know and be familiar with for this lesson. It is “P/E Ratio”. That’s it. It’s pronounced just like that fun class in High School, “pee-eee raysho”. It’s sometimes written without the slash, so just “PE Ratio” or just “the PE”. It stands for Profit/Earnings Ratio and measures the relationship between the price you pay for a single share in a company v.s. how much of that company’s profits over the past 12 months would go to the owner of that share. That’s it. (Experts, just a reminder, I am giving the SIMPLE version!)
So an example of a PE ratio would be the following:
Company X has 100,000 shares. These shares are currently being sold at $500 per share. Over the past 12 months Company X has earned $20,000,000 in profit (Good work Company X!!). This means that for every share in Company X the earnings per share would be $200.
EPS: $20,000,000(12 mo. profits) ÷ 100,000 (total shares of Company X) = $200.
Confession: I lied earlier, while I said that PE Ratio is the one term I want you to know, it goes hand in hand with another term “Earnings per Share” or EPS. What we just worked out is the EPS. (Yes it’s just simple division. No, you don’t need a suit and tie to be able to work it out). Now, back to the other term.
So, our PE Ratio would be the price the shares are currently being sold for ($500 each) divided by the earnings per share ($200).
PE Ratio = $500 (share price) ÷ $200 (Earnings per Share)
That’s it. That’s the PE Ratio. I’ll explain why it’s important and how it’s used soon. But review the formula above, if you can work that out on your own, you can find a company’s PE ratio. Yes, it’s that simple. By the way, if you just learnt and now fully understand what I just explained, congratulations. Your expertise level is now on par with an embarrassingly large percentage of the local investing crowd. Again…yes, it’s that simple…for most of the people who you see when you walk into a brokerage anyway. Put on a suit and you might be able to get a job with them as an investment advisor, especially if you’re good at sales… Anyway, I digress.
Now that we understand what the PE Ratio is (BONUS!!! We understand EPS now too), here’s how it is used to pick investments.
When you invest, your goal is to make a profit. The PE ratio allows you to see what level of profit each company on the stock market is making, compared to how much you pay for each of those company’s shares. In plain and simple terms, it allows you to see which companies could be returning the most (or least) profit to you at their current prices. Here is an example of how that is done. For this one I’ll need a second company, we’ll call this one Company Y. I’ll put Company Y’s information below, then work out the PE Ratio for it (and the EPS of course. Can’t leave out the bonus)
. If you want you can check the info, and work it out for yourself to see if you get it (mad easy, you got this, from you have your division button warmed up win).
Share Count: 350,000,000
Share Price: $5
Last 12mo Profits: $400,000,000
Work out the EPS……and the PE……
Let’s see if we got the same answers.
Company Y =$400,000,000÷350,000,000
PE Ratio = $5 (share price) ÷ $1.14 (Earnings per Share)
So, Company Y’s PE ratio is 4.39. I hope you got the same number as I did, if not, recheck and see where you went wrong.
Now, here is the beauty and the real power in PE. It allows you to compare companies no matter what industry they are in, how many shares they have, how happy their employees are…whatever. It gives you a nice, flat basis on which to compare 2 companies.
If you want to know if it would be better to buy shares in the NCB Financial Group (NCBFG) or Caribbean Cream Limited (KREMI) the PE ratio can help with that and allow you to see which one might be a better fit for you. Notice that it can do this even though comparing a small local ice cream company (KREMI) to a regional banking conglomerate (NCBFG) might have been difficult thing.
It can also lead to surprising results, like in our example. Where the smaller company, Company X, that only made $20M in profit, actually turns out to have a better PE Ratio than the huge company, Company Y, who, despite making $400M over the past year, actually has a higher PE ratio.
And yes, when it comes to PE ratios, lower is better. Lower means you’re getting more profit, for less spend. If the PE is a negative number however, it means that the company made a loss in the previous 12 months and then you need more than a PE ratio to evaluate it.
PE ratios also allow you to see what the normal behavior in a stock market is. So for example, on Jamaica Stock Exchange’s Main Market, the Average PE ratio is 19.4 times. (You’ll see this sometimes too, PE ratios being given and ending in “times”. It just the proper way to refer to it. “Company X’s stock price is 2.5 times its EPS. Company X has a PE of 2.5 times or 2.5x. It all means the same thing and the 2.5 is the important part).
Back to the point. PE allows you to know the usual behavior of investors, stocks on the JSE’s Main Market have an average PE ratio of 19.4 times (as at June 14, 2018, this will change as time goes by and stock prices change). This means that on average investors buy Main Market stocks at prices 19.4 times more than the amount of profits those stocks earned in the last 12 months.
So you coming in as an amateur, can very quickly compare the PE, for any company on the Main Market whose shares you’re thinking of buying, to 19.4 to see if, in general terms, what you are thinking of buying is too expensive.
There is more to a decision like that than just the PE Ratio, but it a good start. Chances are, if a company’s shares are being traded for much higher than the market average, then it can be taken as an indication that anyone buying at that price must believe that the company is going to make a larger profit in the future than it has made over the last 12 months (because higher profits lower the PE ratio, and lower profits raise it).
The JSEs Junior Market is a good example of this, smaller companies with huge profit growths are on the Junior Market and so you’ll see that the average PE ratio on the JSE’s Junior Market is 31.3. People are willing to pay more, in General, for a Junior Market company because they expect it to grow profits faster.
One final thing about PE, that I’m sure you’ve picked up by now but I’ll say anyway, it allows you to see if a stock price is actually expensive. Many times people see a price (like NCBFG’s $100) and say that its “expensive”. A stock’s price cannot tell you, on its own, if it’s expensive or not. What does tell you however, is comparing its PE ratio to the ratios of similar companies, maybe companies in the same industry, or companies with a similar makeup as it, or maybe just companies on the same market as it.
That is what actually tells if a share price is expensive. So for the people who say things like “Carib Cement is a better buy than NCB cause it cheaper” ($39 vs $99 per share as at 14/Jun/2018). PE ratio shows us that NCB, with a PE ratio of 12.2 times, is actually a MUCH better buy than Carib Cement, with a PE of 32.5x. (Pulse beats both of those btw, it has a PE of 8.4....hmmm [at the time]). This is also valid when a company is going to IPO. When Wisynco IPO’d at $7.87, a lot of people (including “experts”) were quick to say that price was “expensive” even though the PE at that price was 12.8x (which is well below the Main Market average of 19.4).
[Note, these numbers are all old, they were current when this was originally written in 2018. The concepts and principles remain the same however]
Now you can actually work out PE ratios yourself and make better investing decisions.
I hope you enjoyed this and learned something from it, if you have any feedback at all, let me hear it here, and look out for more next time in this series that is aimed at teaching you how to pick the right stock(s) for yourself.
If you want other information on getting started with investing, check here.
Till next time, ✌🏾.