Money Rehab with Nicole Lapin - A Golden Metric for Evaluating Investments

Episode Date: July 31, 2022

Before you invest in a company, you need to know how to read their P/E ratio. Don't let the jargon trip you up— it's a lot simpler than it sounds. PE class was harder than P/E ratios, trust us. 

It is time to start thinking about holiday shopping, and I'll let you in on a little secret. Get everyone on your list something special from Justin Wine. Justin is legit my favorite wine to give and to receive. With a rich history of accolades, Justin produces exceptional wines and is proud to be America's number one luxury cabernet. Since 1981, Justin has been producing world-class Bordeaux-style wines from Paso Robles on California's Central Coast. As a pioneer of Paso, Justin Wines are what put Paso Robles on the winemaking map. Justin offers curated gift sets, library wines, magnums, and even custom-etched bottles. You can personalize the gifts with a custom message, icon, or logo. Go to justinwine.com and enter code MONEY20 at checkout for 20% off your order.

Justin offers the perfect holiday gifts for clients, colleagues, family, and friends. If you're looking for a special wine to serve at your holiday table, try Isosceles. That's Justin's flagship Bordeaux-style red blend. Whether you're a first-time wine drinker or a wine aficionado, Justin has a wine for everyone, every occasion, and every celebration. Be sure to check them out at justinwine.com and receive 20% off your order for a limited time. Hey guys, are you

ready for some money rehab? Wall Street has been completely upended by an unlikely player, GameStop. And should I have a 401k? You don't do it? No, I never do it. You think the whole world revolves around you and your money. Well, it doesn't. Charge for wasting our time. I will take a check. Like an old school check. You recognize her from anchoring on CNN, CNBC, and Bloomberg.

The only financial expert you don't need a dictionary to understand. Nicole Lappin. One of my goals on Money Rehab is to turn you into the financial expert and empower you to make the financial decisions that work best for you. The best financial advisor for you will always be the person in the mirror. While I'm a very close second, no one, absolutely no one will care more about your money than you. One of the biggest barriers to entry for people like me who didn't grow up with the Wall Street Journal on their kitchen table is the jargon. And boy, oh boy, is there a lot of jargon in finance land, especially when it comes to investing. If you've ever watched financial news, you've probably seen updates on stock prices scrolling at the bottom of the screen. Sometimes those numbers go along with abbreviations like EPS or VAL. I do think it's important to be

able to decipher these abbreviations because it will help you shut down any brokers who try to take advantage of you. Knowing when a stock looks bad on paper can show any broker or advisor that you know what you're talking about. So let's start with one of the most common metrics, P-E ratio. So the big picture is that the P-E ratio represents the relationship between a stock price and the earnings per share. Let's not worry about earnings per share right now, but what you do need to know is that it's a measure of the company's profitability, specifically with respect to investors. I will say the P-E ratio is the metric that can often

be the biggest mindfuck, but don't let it get you. You have done way harder things in P-E class than calculating P-E ratios. As we get into the nitty gritty, keep this intel as your north star. PE ratios are used to help investors gauge how much bang they're getting for their buck or whether a company is really worth how much people are paying for it. Most data on stocks will give you the PE ratio, but you can also calculate it yourself. You do that by dividing the stock price by earnings per share. And again, we don't have to talk about earnings per share just yet. Just remember, it's a metric that investors look at to see how profitable an investment might be. Okay, so let's

look at an example. Let's say you're looking at investing in a company called the Money Rehab Company, and you know the stock price is $20 and the earnings per share is $10. To find the P.E. ratio, you would divide $20, the stock price, by $10, the earnings per share, and get a P.E. ratio of 2. The way to think about this equation is that the stock price, the numerator, is the investor's lane, right? That's their offering, what they put in, their end of the bargain. The earnings per share, the denominator, is the company's lane. It's the measure of the company's value to an investor. Even if our fraction days are long behind us, we probably sort of kind of remember that if the numerator is bigger than the denominator, your ratio is going

to spit out a bigger number. Well, if you have a relatively bigger number as the denominator, your ratio is going to spit out a bigger number. While if you have a relatively bigger number as the denominator, you're going to get a lower number. And don't worry if you just lost me. I am not going to drill you with the ghosts of math classes past. But remember here that the numerator of this fraction represents your, the investor's, contribution. So when the P-E ratio equation spits out a bigger number, that means your contribution is relatively higher than the company's. You with me? If so, it will make sense to you that typically conservative investors say the lower the P.E. ratio, the better. The lower the P.E. ratio, the more value you're getting from the company. And of course, as investors, we're going to want

all the value we could possibly get for what we're spending our money on. If the P.E. ratio is high, that means you're paying a high price for a company that has low earnings per share. If that doesn't feel ideal to you, you're right. You'll typically see that conservative investors feel that a P.E. ratio of 15 is good value. Let's gauge that with some of our value stocks. At the time I'm recording this, Verizon's P.E. ratio is 9, JPMorgan Chase's P.E. ratio is 10, Goldman Sachs is 7. But let me pop this nice, neat illusion. At the time I'm recording this, the Walt Disney Company, one of the largest companies in the world, has a P.E. ratio of 278. Are you thinking, Levin, you just told us a P.E. ratio of 15 is considered a good value.

Walt Disney is one of the biggest companies in the world. Are you telling me that it's not valuable? No, no, I am not. But here's the catch. me that it's not valuable? No, no, I am not. But here's the catch. A high P.E. ratio means that the investor is contributing a relatively high amount compared to how much profit a company is making. But here's the thing. Low profit, even zero profit, and therefore zero earnings per share, isn't always a bad thing. Does that go against everything you've ever known about business? Before your mouth freezes in the wide open position, let me explain.

There are two reasons a company might not be profitable. First, they suck and they're not making money. That's what we may have assumed and are now seriously stumped because we know that the Walt Disney Company certainly does not suck. The second reason a company might not be profitable is because they're taking all of the money that they're making, their revenue, and putting it back into the company. I've alluded to this a few times and we'll get more into this in future episodes, but a company that's pouring money back into its operations can be a sign of a growing company. For example, maybe all of the company's revenue is going straight into a brand new technology

that everyone is going to want to buy. I mean, I'd invest in that stock, wouldn't you? For today's tip, you can take straight to the bank. Head over to Google Finance or Yahoo Finance or whatever you use and start looking at some of the stock tables for the companies that have been in the headlines over the last few years. GameStop, Tesla, Twitter, Apple, and so on. The more you expose yourself to the jargon and decode it,

the more comfortable you'll be with the language of Wall Street. Money Rehab is a production of iHeartRadio. I'm your host, Nicole Lappin. Our producers are Morgan Lavoie and Mike Coscarelli. Executive producers are Nikki Etor and Will Pearson. Our mascots are Penny and Mimsy. Huge thanks to OG Money Rehab team Michelle Lanz for her development work, Catherine Law for her production and writing magic, and Brandon Dickert for his editing, engineering, and sound design. And as always, thanks to you for finally

investing in yourself so that you can get it together and get it all.