How Stocks Are Valued
Price-to-earnings multiple. P/E multiple. Multiple. Whatever term is used, said Jim Cramer on CNBC's "Mad Money," they all refer to the same thing: how stocks are valued.
The multiple measures an aspect of a company's financial well-being, while the P/E ratio specifically is used to tell how much investors should be willing to pay per dollar of earnings. By looking at the multiple, people are able to tell whether a stock is overvalued or undervalued. It's the multiple, not the share price, that people use to deem Pepsi, for example, more expensive than Coke. Even if Pepsi's share price were more expensive than Coke, that wouldn't tell us anything about the companies' value.
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To value a stock, look at where it's trading relative to the earnings per share. That, Cramer said, is what the multiple allows you to do. The multiple can be found by way of this equation: Share price, P, equals the earnings per share, E, times the multiple, M. This shows you how much investors are willing to pay per dollar of earnings. So investors shouldn't care that Coke's stock is trading at $55, but that it's selling for 15 times earnings. Shares of Pepsi might be at $65, but investors only care that it's selling for 14 times earnings.
The multiple is the main way to determine value, but Cramer said growth is another factor to look at. He said it's important for investors to examine how much bigger the earnings will be next year and the year after, etc. Companies with faster growth tend to get rewarded with higher multiples. The more rapidly a business grows, the bigger its future earnings will be. A fast grower, like Chipotle, may sell for 24 times earnings.
But that doesn't mean it's more expensive than a company that's not growing as fast, like Pepsi for example, which is at 14 times earnings. Chipotle deserves the bigger multiple because it has a higher growth rate of 24 percent versus 8 percent for Pepsi.
Multiples, however, aren't static, Cramer said. In different markets, he said investors will pay more or less for the same amount of earnings. Multiple expansion is when they pay more, and multiple contraction is when they pay less.
Earnings aren't static either, he noted. When you buy a stock, you're either making a bet that the E or the M part of the price equation is heading higher. When it comes to earnings, people often talk about the bottom line, profits or net income, which are terms used interchangeably. It's called the bottom line, Cramer said, because the number is the bottom figure on the company's income statement. To tell if earnings will continue to rise, Cramer recommends listening to the company's conference call regarding its quarterly earnings results. The company will talk about its top line, which is revenue or sales. Strong revenue growth tells you there is strong demand for the company's product, which is ultimately key to a company's ability to grow earnings long term.
Another important thing to consider, Cramer said, is the gross margin. It is what percentage of every dollar of sales becomes profit and an indicator of how much money a company can make. To compute gross margins, consider the competition, cost of production and cost of doing business. Businesses with cut-throat competition will have terrible margins, but companies with great market share will have huge margins. Every industry is different, he said.
“You need to know the vocabulary before you can evaluate a stock,” Cramer said. “When you’re comparing, I want you to look at the price-to-earnings multiple, I want you to look at the growth rate, the top line, the bottom line and the gross margins.”
(Written and edited by Tom Brennan and Drew Sandholm)
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