While there are many ways to value a stock, a few basic tools are universal. Today, we’ll touch on the most universal valuation tool of all, the P/E ratio, as well as how useful it is for retail stock investing.
Understanding EPS and P/E
Unfortunately, a “value” stock is not simply the cheapest priced stock you can find. A $2 stock can be, and often is, much more expensive than a $200 stock. To understand why, you must first understand earnings per share (EPS). Each stock is a share, or part ownership, in a real business. That share entitles you to a small percentage of a business’s profits or “earnings.” By dividing a firm’s net income by the number of its shares outstanding, we arrive at its EPS—that is, your cut of the profits for each share you own. One important thing to remember is that higher EPS does not necessarily mean higher profits. A firm may just have fewer shares outstanding. Here’s an example: If Retailer “X” has $1 billion in annual net income, and issues one billion shares, its annual EPS will be $1/share. If Retailer “Z” has the same annual net income but has two billion shares outstanding, its annual EPS will be $0.50/share. EPS is used in conjunction with another valuation tool, the price-to-earnings (P/E) ratio, also commonly referred to as “the multiple.” Simply put, the P/E ratio is a multiple based on companies current earnings that expresses what investors are willing to pay for those earnings. While a stock’s P/E ratio is typically displayed next to its ticker symbol, you can also calculate it yourself quite easily, by dividing a stock’s share price by its EPS. For example, if Best Buy’s share price is $80, and its EPS is $8, its P/E ratio is 10 (80 divided by 8). The lower the P/E, the less you are paying for a business’ earnings. Yet, even then, a lower P/E does not always mean a cheaper stock—and a good value.
Limitations of the P/E With Retail Stocks
The P/E is an important, though somewhat limited, valuation tool when it comes to retail stocks. For starters, the common P/E tracks a firm trailing 12 months of earnings (TTM), but it does not account for the future. Since retail is constantly changing, with retailers falling in and out of favor rapidly, basing valuation on what happened last year can be problematic. RadioShack, for instance, turned a profit in 2011. By 2014, it was hemorrhaging cash and had to declare bankruptcy in 2015. So when it comes to retail, what happens next is just as important as what happened last. Second, a retail stock may also have abnormally high EPS due to a unique event or cyclical period. This could because it had an unexpectedly good Christmas season, closed a bunch of locations, or received a one-time favorable tax ruling. All of these factors will make the stock seem cheap by way of the P/E but, when the following year’s earnings fail to measure up, the P/E will jump in a hurry. All this explains why a $2 stock might not be so cheap after all. The reasons why a high P/E retail stock may be cheaper than a one with a low P/E often have to to do with growth expectations. Historically, the median P/E for all S&P stocks is around 16, but retail stocks often trade at higher multiples.
