If you’re struggling with profitable investing in large-cap stocks, use the price-to-earnings ratio to value large caps to streamline how you actually look for stocks worth investing in.
I’m not forcing you to have a research process, but if you understand what an investment strategy can bring to your investing success, then stick around.
But a word of caution.
The price-to-earnings ratio (PER) is not the holy grail by any stretch, but it certainly makes the job of determining a sense of value for large caps much easier.
And that makes me feel good.
For context, I pursue a large-cap value investing strategy that involves determining what the real-world value of businesses are (intrinsic value) instead of the make-believe values assigned to them by the stock market and its army of commentators.
Translation: massive companies like Apple, Microsoft, and ExxonMobil.
Yeah, I buy those.
But only when they’re on sale.
They call it purchasing shares in a business only when they are selling at a discount to its intrinsic value (margin of safety).
I call it a common sense approach to investing.
Wouldn’t you rather determine the actual, real-world value of a business instead of taking tips from an online forum or a talking head from the mainstream media?
The price-to-earnings ratio helps you to get an understanding of the intrinsic (real-world) value of a business AND whether it has a margin of safety (it’s on sale).
Here’s the best way you can use the price-to-earnings ratio to value large-cap stocks.
How to calculate the price-to-earnings ratio
Before we get to the meat and potatoes, here’s what the PER actually is:
PER = share price, divided by the last reported earnings per share.
The price-to-earnings ratio is a way of appraising the value of a company based on its ability to turn a profit.
Earnings is simply another word for what accountants call net profit, commonly referred to as ‘the bottom line’.
Net profit is all the money a business has made minus the expenses of doing business like rent, taxes, payroll, and insurance.
Earnings per share is the amount of net profit a business has made divided by the number of shares a business has issued to the stock market.
Stay with me here because the bottom is that there is no point in you buying stock in a business that does not know how to make a profit.
Yes, there is a slight learning curve to the PER, but if you want back yourself to learn a profitable investing strategy – and you really should back yourself – then you’re already one step closer to successful investing outcomes.
How to value Apple using the price-to-earnings ratio
Apple’s share price as of this post is $148.11 per share:
Macrotrends notes that Apple’s earnings per share over the previous trailing twelve months (earnings from the previous four quarters combined) is $6.11.
One year’s worth of a business’ earnings seems like a pretty good yardstick, right?
Apple’s share price (148.11) divided by its earnings per share (6.11) = a price-to-earnings ratio of (24.24).
Still with me?
Here’s a word of caution.
The pitfalls of the PER and how to deal with them
Many investors despise the price-to-earnings ratio (PER) as a measure of value.
They’ll say things like ‘managements manipulate earnings with accounting gimmicky to make earnings look better than they actually are’.
And they are absolutely correct.
It IS the case that accountants can and do manipulate earnings to make their business look as though it makes more money than it actually does in real life.
Everyone’s a hustler these days.
Also, some businesses are cyclical; their earnings may be extremely low or negative in one year.
In other years earnings may be extremely high.
Cyclical businesses sell ‘non-essential’ goods and services such as Walt Disney (DIS).
Although in my household, a Disney subscription has been essential since 2020.
Here’s an earnings breakdown for Walt Disney from Macrotrends that shows how earnings per share (EPS) can be ‘cyclical’:
Earnings consistency (or lack of) like this makes it difficult to value a company based purely on its earnings from one year to the next.
You’re much better off getting hold of a chart of the historical PER. It will help you to visualise past earnings value and compare it to where a stock is trading today (see below).
The Macrotrends website has historical for Apple as it does for hundreds of stocks.
Its screener is pretty awesome as well.
REVELATION: I hardly ever purchase a large-cap stock more than 20 times earnings.
The higher the price you pay for a stock based on its earnings, the higher the likelihood the stock will collapse in price after you’ve purchased it.
It’s the (value investing) law.
Combining the use of charts with the price-to-earnings ratio
A PER chart will show you where a stock has traded in the past based on its earnings so you can get a sense of where ‘value zones’ are.
Here’s Apple’s PE ratio chart from Finance Charts:
Working from right to left you can easily determine where the PE ratio is (24).
Then as you scan toward the left, you should begin to see that significant troughs at just above 10 times earnings have been the ‘deep value zone’ for Apple over the previous 14 years.
These deep value zones are where Apple stock sold at its cheapest.
Where they had the widest margin of safety between low price to earnings versus its real-world value.
More generally, you can easily determine that a PE ratio significantly below 20 for Apple has been a great place to buy its stock.
So as of the date of this post, Apple stock is too expensive to purchase based on a value investing perspective.
Implementing a value investing strategy with the PER
Just because a share price is too expensive for you to buy at today’s price, doesn’t mean it won’t be at some point in the future.
And this is the very heart of what is means to be a successful value investor: patience.
You can have all the discounted cash flow models and 13F filing reports you want, but without the patience to see a value-based strategy through, it simply will not work out to be a profitable strategy.
- patience to wait for the right price
- patience to do your due diligence on each stock before the purchase
- patience for the share price to rise in value when bought at a margin of safety, and
- patience with yourself when, even after conducting extensive research on a business, its share price declines
That’s a lot of patience.
Free-to-use websites like Finviz are a great place to start because they have screeners that quickly list the stocks you want.
the Wealth Accumulated newsletter does the work for you by including updates on large-cap stocks.
Warren Buffett famously said:
If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.Warren Buffett
THAT’S HOW LONG-TERM THE VALUE APPROACH IS.
Thanks for making it to the end.
If you’d like to master the art of large-cap value investing to drive investing results, sign up for the free newsletter and get notified of when the next online course opens.