Though the stock market has experienced some nice gains this year, and in general, has seen six years of positive returns, the past few weeks have been a roller coaster of ups and downs. I get excited when the stock market takes a downturn because, to me, it signals a buying opportunity. It signals that it’s time to go hunting for value or to take a closer look at stocks that I’ve admired from afar that may now be selling at a discount.
The same way one closely monitors that suit, purse, or shoe at Macy’s, anxiously waiting, hoping, and praying that it goes on sale, is the same way I feel when there’s a market downturn; I get excited that I can buy shares of stocks, ETFs, and Mutual Funds “on sale.”
Hold up, wait a minute! Before you rush off to buy all these “cheap” stocks and Mutual Funds … are they really “on sale”?
Every “sale” item isn’t worth buying, and the same goes for stocks “on sale”. Not every investment is worth buying. Some investments are still too expensive, and others may be dirt cheap for a reason. So, this week I’ll share two metrics that you can use to compare your investments. There are a multitude of ways that you can compare investments, but these two are simple and, to me, make sense intuitively. Our two metrics are P/E (price-to-earnings) ratio and Net Expense Ratio.
P/E ratio applies to stocks. Mutual Funds whose underlying investment consists mainly of stocks may also report an average P/E ratio for the stocks within the Mutual Fund, but for the most part, P/E ratios are used for comparing individual stocks. For Mutual Funds and ETFs, the Net Expense Ratio (I’m going to call it NER for short) is the comparison tool to use.
Let’s start with the P/E ratio. Mathematically, it’s calculated by dividing a company’s share price by its earnings per share. If company X is trading at $50/share, and its most recent earnings (annual profit) is $5,000,000 and it has 1,000,000 shares outstanding (the number of shares that all investors own), then the company’s P/E is 10 [50/(5,000,000/1,000,000)]. That’s the calculation for P/E, but how do you apply it?
Think of your daily, weekly, or monthly trip to the grocery store. Do you look at the unit price of an item and compare it to similar items before deciding which brand to buy? I recently went shopping for toilet paper and had to choose between two brands. I had used both brands before and noticed no difference in quality. Each brand had six rolls per pack, but Brand A had a price of $7.20 per pack, while Brand B had a price of $8.50 per pack. Naturally, my first instinct was to buy Brand A because it was cheaper, and both brands had comparable quality. However, upon closer inspection, I noticed that the rolls in Brand B were larger. Brand A had 100 sheets per roll, while Brand B had 125 sheets per roll. The unit price for Brand A was $0.012/sheet and the unit price for Brand B was $0.009/sheet. By comparing the unit prices for each brand, I was able to compare “apples to apples” and determine the brand that was truly cheaper.
P/E ratio can be used in a similar manner. Stock A may trade at $10/share while Stock B trades at $15/share, yet Stock B could be the “cheaper” stock. You can’t tell from the price of a stock alone whether it’s cheap or not. You have to compare it to other stocks, and to a relevant index such as the S&P 500. A note of caution: to appropriately use P/E for comparison, the stocks should be similar in various ways e.g. in similar industries. You wouldn’t compare the unit price of toilet paper to the unit price of coffee, so you shouldn’t compare the P/E for a startup Biotech company to that of an established company, or the P/E for a technology company to that of a consumer goods company.
In general, the P/E ratio for individual stocks is compared to the P/E for the S&P 500. It is a good place to start, but it is best to narrow the comparison to stocks within the same industry, stocks of same sized companies, etc. All things being equal, the lower the P/E of a stock when compared with others, the better.
However, just like you would be cautious of that Prada handbag selling for $10, you should take a closer look at a stock that has a significantly lower P/E ratio than its peers. There may be a reason for it.
Let’s take a look at NER. NER is the net expense incurred for the management of the Mutual Fund or ETF that you purchase (expenses such as administrative costs and management fees). NER is in addition to the actual cost of purchasing the investment. So how do you use NER as a comparison tool?
Think of the last time you had to withdraw money from an ATM that wasn’t your bank’s ATM. The quality of service and the process for withdrawal is comparable from one ATM to the next. However, the fees vary. The ATM at the gas station may charge $3 per withdrawal, while the ATM at the grocery store charges $2. If you are in need of $100 at the gas station, you’ll have to pay $3 to withdraw money from the ATM. That’s an expense ratio of 3%. If you’re at the grocery store instead, then the expense ratio drops to 2%.
Imagine if you weren’t aware of the cost for withdrawing money, and you indiscriminately withdrew money from any ATM without a second thought. You wouldn’t realize that you are keeping less of your money by withdrawing money at the gas station instead of the grocery store or your bank. (Hopefully a close look at your bank statement would clue you in!).
You can use NER in a similar way to compare Mutual Funds or ETFs that provide similar risks and similar return on investment. Say Mutual Funds A and B both report annual returns of 8%, and both cost the same to purchase, but Mutual Fund A has an NER of 0.8% and Mutual Fund B has an NER of 1.1%, then Mutual Fund A is the cheaper investment. Your net return from Mutual Fund A is 7.2%, while it is 6.9% for Mutual Fund B.
As with the stocks example, you have to make sure the Mutual Funds or ETFs that you are comparing are similar. For example, Mutual Funds consisting of international stocks have higher NERs than Mutual Funds consisting of domestic (U.S.) stocks.
Remember, before you run off and buy that “cheap” stock, Mutual Fund or ETF, go comparison shopping. That investment may not be as cheap as you think, or may be cheap for a reason!
Topics discussed:
P/E ratio
Net Expense Ratio
Earnings per share
Shares Outstanding.