Wealth Accumulated

By D J Thomas, a value investor who writes

Benjamin Graham

How to use the price-to-earnings ratio to value large-cap stocks

Man at a desk with phone in hand working on price-to-earnings

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.

Pause.

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).

Perfect right?

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.

Phew!

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’:

10 years of Walt Disney’s annual earnings

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:

From 4th November 2008 to 25th November 2022

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.

You’ll need:

  • 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.

The most profitable stock market investing strategy of all time

Profitable stock market investing

I’ve talked for years about how Benjamin Graham, the father of value investing, taught the public a profitable stock market investing strategy without relying on Wall Street or The City to do it for you.

One advantage of a DIY approach to stock market investing is that you will cut out the fees professional money managers will charge you.

They will often charge you fees even when they lose you money in bear markets or they are simply unable to beat the S&P 500, which most of them cannot.

You can simply buy a low-cost S&P 500 index fund in your broker account and make more money over the long term than the vast majority of professional money managers.

But you’re here because you’d like to understand how a more sophisticated approach to making money from the stock market can yield even better results over a long-term time frame.

The Relatively Unpopular Large Company

The Relatively Unpopular Large Company is the name Benjamin Graham gave to a value investing strategy that is simple to understand so that you can start using it once you get to grips with it.

Graham described the strategy as ‘conservative and promising’:

The key requirement here is that the enterprising investor concentrate on the large companies that are going through a period of unpopularity

Benjamin Graham, The Intelligent Investor

The key skill you’ll need to develop is determining that the period of unpopularity is temporary.

But more on that later.

Let’s break down how this strategy works.

Concentrate on large-cap stocks for profitable stock market investing

Concentration on the largest of stock market listed companies ensures that over time, you’ll develop an intuition, a sixth sense within the large-cap space.

Familiarity does not breed contempt in this situation.

Trying to invest in stocks of all shapes and sizes can be done, but we are here to develop a niche skillset in the ‘safest’ part of the market.

For one thing, large caps are the most talked about, followed, analysed, and written about stocks in the world.

This means that your research process on individual stocks going through a period of unpopularity begins with a simple Google search.

More importantly, large-cap stocks and the businesses behind them employ the brightest minds in the world.

That intellectual capital is what Ben Graham was relying on when he said of this strategy:

The large companies thus have a double advtange over the others. First, they have the resources and capital in brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.

Benjamin Graham, The Intelligent Investor

Look for stocks with a market capitalisation of at least $10 billion, many of them being household names familiar to you.

Yahoo Finance, Google Finance, and many other free services will give you this information.

If you’re a European investor then indexes like the FTSE 100 in the UK, the CAC 40 in France or the DAX in Germany offer convenient lists of large caps to research from.

Determine if the period of unpopularity is temporary

Guesswork will not do for this or any aspect of the strategy.

You will need to do some research if all of a sudden your news-feed flashes the headline ‘XYZ large-cap stock has collapsed in price today’.

Here is a starter list of questions you’ll need to answer to help you determine the timeline of unpopularity:

  • Why did it collapse in price?
  • How short-lived is the issue that caused the price collapse?
  • Does it have a strong balance sheet?
  • Has it hit 52-week or multi-year lows?
  • Is the general market in a bull or a bear market?
  • What is the long-term (10+ years) dividend record?
  • How likely will the company ‘turn itself around’ based on what management v what The Street says?
  • What is the PE ratio average over the past ten years (PE10) compared to the PE ratio over the last twelve months?
  • Has the long-term return on capital employed (ROCE) been historically high? (at least double digits).

Some of these questions are abstract and will have no definitive answer.

Some of these concepts like PE10 or ROCE will be new to you and are based on mathematics.

In both situations, the research process is about building a picture of the long-term success or otherwise of a business, where it sits in the current business environment, and how well based upon your research you think the business will turn itself around after a setback.

Learning about PE10, ROCE and other useful financial ratios is part of the process of becoming a better, intelligent, and enterprising investor.

It is the difference between dollar cost averaging with a low-cost S&P 500 tracker (set and forget) or seeking a higher reward for more work.

Sometimes you will not have a clear yes or no answer as to whether the unpopularity of a company will be temporary.

In this scenario, you should simply place the stock on a watchlist and monitor the news flow about the stock.

You would have already done the hard work of researching it, so it’s best not to waste that work.

Keep it on your radar, monitor news about it, and gain a better understanding of the business to determine when it’s time to buy.

Is investing in large-cap stocks a good fit for your mindset?

At the start of this article, I stated that the relatively unpopular large company strategy was the most profitable of all time.

Warren Buffett uses something close to this strategy, with a focus on large businesses that have shown consistent growth and a historically high return on capital employed (ROCE).

Buffett also buys businesses outright and has a vast pool of cash to play with, and combined with his reputation, he creates deals that we cannot.

That said, he is the wealthiest most successful stock market investor of all time and his investing mentor happened to be Benjamin Graham, the inventor of this strategy and the father of value investing.

But before you stride out there on your lonesome, a word of caution.

There are hundreds of articles, white papers, and books written about the best stock market investing strategies in the world.

What the vast majority of them lack is what I call a ‘mindset fit’.

This mindset fit is the distance between a stock market strategy and the way you think as an individual.

If you think you need charts, indicators, and a constant refresh of your broker’s app for stock market prices every 15 minutes then this strategy of relatively unpopular large companies is not for you.

You’ll likely need a short-term trading strategy based on technical analysis.

If you value your time to enjoy what the world offers without having to look at charts and stock prices all day then the relatively unpopular large company is for you.

Most of your time will be spent keeping abreast of financial market news rather than staring at charts and prices.

Value investing is by its very nature long-term orientated so when you actually purchase stock in a large cap undergoing a temporary period of unpopularity, the price may not rise straight away and may even go lower before going higher.

This is exceptionally difficult for most people to accept which is why they feel the need to check stock prices constantly.

Checking the news is a much better use of your time since large caps tend to pay dividends whilst they sort themselves out.

Subscribe to the newsletter so that you’ll not miss another article on large-cap stock market investing and follow along with my own portfolio news and performance because I use this very strategy to make money from large-cap stocks.

The best book on investing ever written

It’s a pretty bold statement: the best book ever written on stock market investing.

Thing is, I don’t even READ book reviews so I can’t see book reviews happening too often around here.

Twitter lists of top 10 books on investing, finance, or whichever subject catches my wandering attention, and buying the titles that have a habit of appearing most often is my preferred method of book shopping.

So when I do muster up the minerals to write a review, it means I’ve found a book so compelling that I have to share it with you.

Mercifully I can save you the hassle of trawling through the rest of today’s article and just put it out there: you need to buy The Intelligent Investor by Benjamin Graham.

This book is exceptional, especially if you:

  • are a bit lazy like me
  • want to understand the basis of my personal investment style
  • want the simplest low-risk and profitable investment strategy that you could ever find

That last one is a lie.

The simplest low-risk and profitable stock market investment strategy is to purchase a low-cost tracker fund every month from your wages or as a lump sum – depending on your wealth status – and keep purchasing it then leave it for 40 years.

Set and forget.

I want more CONTROL than that though, don’t you?

But not too much; remember we’re a little lazy. And that’s okay.

Don’t you want to make sense of the stock market that most people view as a giant casino?

Spoiler: the stock market IS a giant casino backed by trillions of dollars made up out of thin air.

But that’s an article for another time.

Here’s why the Intelligent Investor by Benjamin Graham is the best stock market investing book of all time

The investor’s chief problem – and even his worst enemy – is likely to be himself

Benjamin Graham

There is enough quote-worthy wisdom within the pages of The Intelligent Investor to fill a beer barrel.

It’s superb for the occasional tweet/social media post when you’re pushed for time to create content.

See what I mean? Even if you may not know what the margin of safety is. Chill.

Downsides?

It was written in 1949 with 1949 language.

It’s author, Benjamin Graham, was not only known as a superb mentor but also forhis intellectual acumen.

He would famously quote passages of Cicero .

From memory.

But it’s well worth the effort to get to grips with a transformative investment style that has helped professional fund managers and the general public, you’ll see.

Among the opulence of Graham’s guidance is his stated aim: to appeal to EVERYBODY, regardless of your station in life or financial literacy.

From the local parish priest to the multi-billion dollar fund manager.

Oh, and Graham’s strategies have stood the test of time since the book was first published in 1949.

It works. It still works. And it will continue to work, especially in developed Western financial markets.

The secret sauce of the value investing approach that Graham pioneered is a strategy for your lifetime and those of your grandchildren.

One strategy in particular called the relatively unpopular large company is a profitable, low-risk, value investing strategy that I use to this day with great success.

It appeals to both the lazy and risk-taker in me.

Perhaps it can for you.

These characteristics are suited to the value investing approach: buy stocks when they’re cheap, and sell them when they’re overvalued.

Do nothing in between.

The relatively unpopular large company

This investing strategy is about as basic and low maintenance as it gets.

You’re not asked to pour over financial statements, spend hours interpreting breaking news items from the so-called financial media or pull yourself away from the golf course.

Trigger warning: I’m assuming that you play golf, drive a Volvo, and own a labrador.

If you do then you’re winning at life.

The relatively unpopular large company is a paint-by-numbers strategy:

  • Buy only large-cap stocks
  • Buy them when they are experiencing a period of temporary unpopularity
  • Make sure you buy enough to diversify your portfolio

That’s it.

What’s more, there are different types of value investing approaches for you to choose from if you don’t like this one.

If you feel a more thorough approach to investing is your bag, then there’s one in there for you.

It just depends on how much time you’d like to spend away from the 18th hole.