pH Balance & P/E Ratios
By Kara Stefan
Remember those shampoo commercials that tried to convince you to buy the product because it was pH balanced? It sounded like a bunch of hoo-hah, but we bought it anyway because this technical explanation seemed to prove the shampoo was a better value.
Nowadays you hear a lot about P/E ratios when analysts recommend which stock to buy. Technically speaking, P/E stands for price/earnings, and it measures a company’s future earnings prospects. The ratio is determined by dividing the stock price by its earnings per share; the higher the ratio, the higher the earnings expectations. Of course, that might sound like even more hoo-hah.
In plain English, a P/E ratio is like pH balance. Yes, there’s some measure of technical validity behind it, but it’s basically just a way to evaluate a stock in the same way you look for value in any product you buy.
Emotional Barometer
A very smart man named John Bogle, who happens to be senior chairman and founder of the Vanguard Group of Mutual Funds, once described the price-to-earnings ratio as a measure “not of reason but of emotion.” And that’s really all it is.
A P/E ratio basically represents the “perceived” value of a stock. To give you an everyday analogy, let’s compare department store cosmetics to drug store make-up brands.
Some women are willing to pay more for Lancome cosmetics because they believe they are higher quality products. Other women believe that L’Oreal cosmetics represent greater value because they get the level of quality they seek at a lower price.
Fools Rush In
Sometimes P/E ratios are accurate. Other times–such as during the recent bull market for technology stocks–ratios are considered way over-valued. That means it’s unlikely the company will achieve the future earnings predicted by its P/E ratio. However, just because a stock is over-valued doesn’t mean it’s not a good stock.
Take, for example, the price of a loaf of bread. Say a new bakery opens up and its new all-natural, whole grain bread becomes the rage in your community. Everyone in town is buying it, even though the price is six bucks a loaf. If you can afford to buy a $6 loaf of bread, knock yourself out. If not, there’s nothing wrong with your garden variety Sunbeam for a $1.49.
Both are quality loaves, but you’ll buy the one with the best perceived value for you and your family. Obviously, that value differs among consumers.
Buy What You Know
Author Oscar Wilde once ridiculed those “who know the price of everything and the value of nothing.” Since women tend to be the seasoned shoppers of the household, we are uniquely qualified to understand the value of a product in relation to its price.
When considering what stocks to buy, don’t get sold on high P/E ratios–but don’t be put off by them either. If a company is sound, then it’s sound regardless of what everyone else says about it or pays for its shares of stock.
In her book, The Million Dollar Car and $250,000 Pizza, author and CFP Allyson Lewis tells the story of her grandmother, Mary Nell Wortham, who became actively involved in stock investing at age 79. She bought Coke stock because she liked to drink Coke, and she didn’t sell the stock when the company changed the product’s recipe in the 1980s or after the market crash of 1987. She never sold the stock because she never stopped enjoying a bottle of Coke.
Over a 16-year period, her stock split four times and she ended up with $750,000, borne out of her original investment of $36,000.
The moral of this story is: Shop smart, like you do at the grocery store. Buy what you know, and don’t waiver just because everyone else is rushing out to buy the new flavor of the week or because the stock price takes a temporary nose-dive or because analysts say its P/E ratio is overvalued.
Just remember why you bought the stock in the first place, and you’ll do just fine.