P/E Ratios

When you hear someone say Apple is trading at $130 or Exxon trading under $85, what does that mean?

Apple is trading at a higher price than Exxon, but we don't actually know from that if one is a better price than the other. The reality is that knowing that Apple trades at $130 doesn't tell you a darn thing!

It's important to get a second piece of data, the company's earnings per share (EPS), to have any sense of how to compare the price of Apple (AAPL) shares to Exxon (XOM) shares. Taking the price divided by earnings per share gives you the company's P/E (price-to-earnings) ratio.

There are many flavors of P/E ratios for a given company, so you always want to make sure you are clear on just which one people are talking about. Unfortunately, you'll often hear people on the major financial television shows talking about P/E ratios without specifying to which they are referring, which annoys us to no end.

The numerator is always the current market price, but the denominator can vary widely, from being the last four quarters of earnings-per-share (trailing P/E ratio, which is typically annotated as TTM), the expected earnings per share for the next four quarters (forward P/E ratio), and even the past two quarters combined with expectations for the next two quarters (blended P/E ratio).

Say that Apple's trailing 12-month earnings per share (EPS TTM) was $7.40 while Exxon's was $7.60. Now we can calculate the price-to-earnings ratio (P/E) (trailing 12 months) for these two stocks:

PE ratio (TTM), which is the price-to-earnings ratio, trailing 12 months:

What this tells us is that investors are willing to pay $17.16 for every $1 of Apple's earnings versus $11.18 for every $1 of Exxon's earnings. Now we have a way to better compare Apple's share price to Exxon's. From this, we can see that Apple is trading at a more expensive multiple than Exxon. Two other ways to say this are as follows: Apple shares are trading at a premium to Exxon shares or Exxon shares are trading at a discount to Apple shares. Generally, a higher P/E ratio means that investors are anticipating higher future growth. P/E ratios tend to be more consistent within an industry so we are not surprised to see a wide discrepancy between Apple and Exxon here. In Chapter 10, we'll show you how to use this metric to compare companies within the same industry or peer group.

We should also mention that the P/E ratio can be used for more than just an individual stock. It can be used for a fund or an index, which is simply the weighted average of the P/E ratios for all the companies in the fund or index. For example, the Shiller P/E ratio (named after economist Robert Shiller) is based on the average inflation-adjusted earnings from the previous 10 years for the S&P 500 index.

In November 2015, the Shiller P/E ratio had long-term average of around 16.6 with a peak of 44.19 in December 1999.¹ Let's assume that today the current Shiller P/E ratio is 27 and the S&P 500 trailing 12-month P/E ratio (current stock price divided by the training earnings per share for the past 12 months) is 20 versus 18 a year ago and its forward P/E (current stock price divided by the expected earnings per share over the coming year, which you can find from FactSet and other services) is 17. So:

What does this mean? Stocks are more expensive today than a year ago.

Investors are paying more today for each dollar of earnings from the S&P 500 than they did a year ago and also more than the historical average, since the trailing 12-month P/E ratio rose from 18 to 20.

Earnings for the S&P 500 are expected to grow over the coming year, which is why the forward P/E ratio is lower than the trailing P/E ratio. Here's the math:

Most investing services provide P/E ratios for individual companies, funds, and indexes, often giving both the trailing and the forward, as P/E ratios are pretty much the standard for assessing where a stock is overpriced, underpriced, or fairly priced. However, there are some things you need to take into account when using the P/E ratio.

First of all, a company's net income (earnings per share equals a company's net income divided by its outstanding shares) can be manipulated in a variety of ways. For example, a company may take a one-time restructuring charge, which it could use as an excuse for having weak earnings, and will prefer to talk about pre-one-time-charge net income instead of the actual earnings. This could be legitimate if the one-time charge is truly a unique event and does not reflect typical operating expenses, but we've seen more than a few occasions where companies have reported these “one-time restructuring charges” every few years. This looks to us like a great way to play with accounting in order to make typical operating expenses look less than they really are. There are so many accounting games that companies play in order to paint the best picture possible of their net income that countless books have been written on the topic of managing a company's bottom line. So investors…beware!

Share Repurchases

Companies can reward shareholders in a number of ways, including through stock price appreciation and dividends. One way that has become increasingly popular is share repurchases (also called stock buybacks). This refers to when a company buys back their own shares. Generally, when companies buy back their own stock it is beneficial to shareholders, because with fewer shares outstanding, those shares that are in the public's hands are worth more.

However, with the exceptionally low interest rates after the financial crisis, we have been seeing a significant increase in the number of companies buying back their own shares, with a growing percentage of them issuing debt to do this, thanks in no small part to the various quantitative easing programs that have kept interest rates at exceptionally low levels. Figure 9.2 shows the increase in share repurchases in recent years.

For companies that issue debt (bonds) to fund share buybacks, the benefit to shareholders is more complicated than when the buybacks are funded through normal business profits. When the interest rate paid on the bonds is lower than the dividend yield on the shares being repurchased, this is a cash-flow-positive strategy. Here's the math, using small numbers to keep it simple.

A company's stock is trading at $100. The current stock dividend is 4 percent on an annual basis, which means it is paying $4.00 in dividends on every share per year.

The company issues $1,000 worth of bonds, yielding 2.5 percent. This means that if you bought $100 of this bond, you would receive $2.50 a year in interest payments. The company uses the proceeds of the bond issuance (the $1,000) to repurchase 10 shares of its own stock (). Now the company is paying only $25 a year in interest versus the $40 it was paying previously in dividends on those shares, saving $15 a year.

Looking at those equations one can see how low interest rates (a la Federal Reserve quantitative easing) could make it more attractive for companies to buy back their shares and would put downward pressure on dividend yields. Let's look at the top 10 companies by dollar-value and their share returns in late 2015 as shown in Figure 9.3.

How could these share buybacks affect share prices and not just reduce the amount of money companies pay out in dividends?

The price of a stock on any given day is just a function of supply and demand. The greater the demand (buyers) the more the stock price is pushed up until no more buyers are interested at the higher price. The converse is also true; the more that want to sell, the lower the price will go until no more sellers are interested in selling. (Real-world example—when home prices are high, lots of people consider selling their homes, but when home prices fall, more people are happy to stay just where they are.)

So how big of an impact do these share buybacks have on demand? We can answer this by looking at fund flows, meaning money going into and coming out of the markets, shown in Figure 9.4.

The chart on net equity inflows shows that the single largest source of funds going into the equity markets came from corporations. Households on the other hand were net sellers, as were pension funds, meaning that on a dollar basis, more households and pension funds were selling than buying stocks. Further, it shows that in 2014, households took $183 billion out of the stock market while corporations put $415 into the equities market. Doing some simple math we find that if no corporations had purchased equities, there would have been a net outflow of $237 billion! Talk about a reduction in overall demand. What this tells us is had it not been for companies buying back their own shares, stock prices in 2014 would have likely declined as there were overall more sellers than buyers.

Now let's go back to the company making the decision to issue bonds (borrow money) and use the proceeds to buy back shares of their own stock. There are a few things to keep in mind: This is not a sustainable process. Companies cannot endlessly issue debt and then use the proceeds to buy back shares—rather intuitive, but something to keep in mind, as it is not a long-term way for a company to generate returns for shareholders. As debt levels climb at a company, shareholders may become increasingly worried that the company will not be able to service its debt (meaning being able to make the required payments). This is akin to a homeowner repeatedly refinancing their home, with each successive mortgage borrowing even more than the one before. In a contracting economy or in a recession this problem can become even more worrisome.

If stock prices fall, then the entire equation we did above falls apart. How's that? Well, we left out the impact of share price and the company's balance sheet in that analysis. Tricky, aren't we? So let's revisit that equation taking share price into account.

The company issues $1,000 worth of bonds and immediately buys $1,000 worth of stock, or 10 shares since the stock was trading at $100/share. So on the company's balance sheet there is now a liability worth $1,000, but an asset, most likely cash, that is worth $1,000 counters it.

If the company's stock were to decline by, say, 15 percent, then those shares would be worth $850. The company now has a liability worth $1,000 that is countered by an asset worth only $850. This negative change in the company's net worth makes it less attractive than before the share price decline, so now it has a double hit. Its shares have been falling and now its balance sheet looks less attractive. That can put further downward pressure on the company's share price, which results in an even less attractive balance sheet, and so on. This is another example of how debt can exacerbate problems when asset prices fall.

One of the reasons that companies do this is the difference in tax treatments between debt and equity. Remember how we discussed earlier in this book the way fiscal policies (a.k.a. tax and spend) can affect investing? Companies are able to use the payments they make on loans to reduce their taxable income. Dividends paid to shareholders are completely different. Companies first have to pay taxes on their net income; then they can distribute what remains to shareholders. Shareholders then must pay taxes on the dividends they receive. This is referred to as double-taxation. The same income is taxed once at the company level, then again when received by shareholders. Companies may choose to use some level of debt to help reduce the amount of taxes they pay, leaving more money to give to shareholders.

Most importantly, these share buybacks affect earnings per share (EPS) as the fewer shares outstanding, the higher the earnings per share for the same net income. For example, if a company has 100 shares outstanding and buys back 20 shares, its earnings per share will look greatly improved, even though the company's actual performance is the same!

This makes comparing performance over time using P/E ratios rather convoluted as the P/E ratio is based on price and EPS.

As you can see, there are no quick answers when assessing the value of a company's stock. There are many things a company can do to manipulate its numbers, so you need to look at more than just one or two metrics to understand performance over time. In the next chapter, we will give you a checklist to help you get an understanding of the key data points as efficiently as possible.

Now that you better understand some of the ways that a company's earnings-per-share can be manipulated and how to calculate various price-to-earnings ratios, we'll walk you through a few other types of securities that you might be interested in using to execute on the investment Cocktail Thematics you have identified.

Exchange-Traded Funds versus Mutual Funds

The various structures of ETFs vary by country, but the fund itself is divided into shares, which are held by shareholders who then indirectly own the assets of the fund and are thus entitled to the profits, dividends, and interest generated by the assets of that fund.

ETFs differ from mutual funds in that investors do not buy or sell their share at the net asset value (NAV), which means essentially the value of the underlying assets.

For example, to calculate the NAV for shares representing one-tenth of a fund that owns 20 shares priced at $5.00 and 10 shares priced at $20 would be . This is basically how the NAV for a mutual fund is calculated every day after the markets close, except it's done for every security the mutual fund owns.

Since an ETF is constantly traded throughout the day at the same time as its underlying assets, the price of shares of the ETF is determined the same way as prices for stocks, by the matching of buyers and sellers, which means that at any point in time, the ETF can be trading at a premium (priced above) or a discount (priced below) to its NAV. Using the previous example, this means the shares could be trading at, say, $31 (a premium) or $29 (a discount), even though the underlying assets are worth $30.

The difference between the fund's underlying NAV and the current share price is kept in check by the process by which the financial institutions (such as JP Morgan, Morgan Stanley, or Citibank, with whom you directly buy and sell ETF shares) purchase and sell the ETF shares directly from the ETF provider. This is done in large blocks of usually around 50,000 or so shares, which are called creation units. The ability to purchase or redeem creation units for an ETF gives these institutions arbitrage opportunities when the NAV of the bundle of securities is more or less than the market price of ETF, which in turn serves to minimize the potential difference between the two. They can make money taking advantage of the difference and, as they do, the difference shrinks.

ETFs can be bought only through a brokerage account, just like buying a stock. In contrast, investors can usually buy or sell mutual funds directly through the fund provider, such as Fidelity, Vanguard, PIMCO, and so on. Mutual funds also typically have a minimum investment, such as $1,000, whereas you can purchase just one share of an ETF, which is typically far less than $1,000.

Since ETFs trade on the market like stocks, investors can engage in many of the same types of trades that they can with a stock, such as selling short, buying on margin, and often times options in the form of calls and/or puts can be written against them. ETFs generally have lower costs than mutual funds for a variety of reasons and are more tax efficient for investors:

• ETFs that track an index have lower management fees because they are not actively managed.
• ETFs are insulated from the costs of having to buy and sell securities when shareholders purchase or redeem shares, which reduces costs and reduces potential tax liabilities for investors.
• ETFs usually have lower marketing, distribution, and accounting expenses than mutual funds.
• Most ETFs are not subject to 12b-1 fees, which are annual marketing or distribution fees associated with mutual funds.
• Index-style ETFs generate relatively low capital gains because they have low turnover of their portfolio securities.

In 2002, ETFs had a mere $100 billion under management. By 2006, that total had gone to $400 billion. By 2009, it was $800 billion, and by the end 2014, it had mushroomed to $2 trillion. To put that into perspective, $2 trillion equates to each of the estimated 322 million U.S. citizens holding more than $6,200.

That's impressive, but by the end of May 2015 the global exchange-traded products industry reached US$3 trillion in combined assets under management. At the time, Goldman Sachs saw that figure doubling by 2020 due to rapid adoption of ETFs and similar products by “registered investment advisors (RIAs), the roll-over of 401(k) into IRAs, increasing use of auto-allocation products, regulatory push into lower-cost products, geographic expansion, and innovation.” As you'll read in the next section, not all ETFs are the same.

There is one other key difference between mutual funds and ETFs. Mutual funds typically only disclose their holdings on a quarterly basis, which means the fund manager can execute a strategy without the world seeing what he or she is doing and trying to take advantage of that information. Exchange-traded funds, in contrast, are required to disclose their holdings on a daily basis, which makes it more difficult to execute an active investment strategy as the world can watch the fund manager's every move.

Types of ETFs

Most ETFs are index funds that seek to replicate the performance of a particular index such as the S&P 500 or even a particular set of bond maturities like Treasury bonds with a maturity of 20 years or later with the iShares Barclays 20+ Year Treasury Bond ETF (TLT). These ETFs can either replicate the index by investing 100 percent of their assets proportionally in the securities underlying the index or engage in representative sampling where as little as 80 percent of their assets are invested in the securities and the rest is in options or futures or other securities not in the underlying index with the intent of helping the fund meet its investment objectives.

Stock index ETFs can be focused on a particular type of company, such as companies with large market capitalization such as Apple, or growth companies or high-dividend-paying companies. They can also focus on particular sectors such as biotechnology, banking, or even airlines.

Bond ETFs can be focused on particular types of bonds, such as U.S. government Treasury bonds, municipal bonds, corporate bonds, or international bonds with varying maturities.

There are also ETFs that track everything from the price of gold (such as ticker GLD) and silver (such as ticker SLV) to companies in the agricultural industry (such as ticker MOO) to even wind energy (such as ticker FAN). There are even ETFs that track relative values of currencies or baskets of currencies, and even volatility. ETFs also allow investors to take advantage of leveraged or inverse investment strategies, such as an ETF that seeks to generate two or three times the underlying index or to move opposite the index. Investors need to be aware that these funds can have considerable tracking error. Tracking error refers to just how far off a fund is relative to its underlying index. For example, a fund that seeks to generate two times its underlying index will likely diverge significantly because most all leveraged funds compound daily. If the index reverses direction, meaning up one day and down the next, the fund will be well off its underlying index. Here's the math:

As you can imagine, over time the difference between the two can grow, particularly if there are a lot of reversals of direction. So why does this “tracking” error occur? Because the fund rebalances its assets every day so that it can generate double the index's returns for that day. As long as the index moves in one direction, the fund will be able to track accurately, but once it changes direction, it starts to be off. If you want to leverage an investment over a longer period of time, a margin account, which allows you to purchase, say, $100 worth of shares for only $50, may be a better way to go, but of course you are risking more, too, so this is something to be considered carefully. We'll discuss this in later chapters. There are some funds that seek to compound on a monthly basis, but they will still have the same challenges over longer periods of time.

An inverse or “short” ETF seeks to give investors returns that are the opposite of the index's. For example, an inverse S&P 500 index would give you a positive 2 percent return on a day when the index itself fell 2 percent. However, these funds have a similar compounding problem. Both inverse and leveraged funds will perform as expected as long as the underlying index continues to move in the same direction; once it shifts, game over. Thus, these are particularly challenging funds to manage during volatile times when the index has large moves both up and down. There are also a few different types of ETF structures: exchange-traded open-end index mutual fund, exchange-traded unit investment trust, and exchange-traded grantor trust. Before purchasing an ETF, make sure you understand the details of its structure and the cost and tax implications it will have. Leveraged or inverse ETFs can be useful, but typically only for a short period of time, so make sure you understand exactly how they work.

Regardless of the type of structure, funds can be either actively managed or passive. Passive funds are typically index funds, meaning they attempt to as closely as possible track the performance of a particular index such as the S&P 500, or a specific commodity such as the price of gold, or a specific type of bond such as U.S. Treasury bonds with maturity greater than 20 years, a specific country index like the 50 largest companies in India, or a sector index such as healthcare, biotechnology, cybersecurity, utilities, or even water resources. Managers for actively managed funds buy and sell as they see fit in order to maximize returns and minimize losses. Typically, actively managed funds experience more turnover, meaning more securities are bought and sold, which translates into more expenses for the fund, and charge more because the manager is doing a lot of work. Index funds typically experience less turnover and their fees are notably lower because the manager is simply ensuring that the fund tracks its index as accurately as possible.