Teach Your Kids About Stocks - P/E Ratios

Humans like to classify things and to put things in a framework.  It helps us to think.  In the stock market, important questions are how much should be paid for a stock, how do investors determine if stocks are worth more than their current price (in which case, we want to buy) or worth less, how can we compare stocks?  We need a framework.

An easy exercise for parents and kids to do builds on yesterday's post.

Find the P/E

The starting point for those who use fundamental analysis is the price-to-earnings ratio--aka the P/E.  Suggest a stock to an investor, and one of the first questions is usually what is the P/E?

Let's get at this measure by starting as we did yesterday.  Let's go to Yahoo! Finance.  Find the "Get Quotes" box and type in the ticker XLK.  XLK is an exchange traded fund that indexes (i.e., seeks to match) the technology stock portion of the S&P 500 we learned about yesterday.  Just like yesterday, you come to the page showing the information on the ticker you put in. 

The advantage of using a fund is that it is well diversified.  An exchange traded fund also usually has low expense fees.  It is important to know also that they trade like stocks and, therefore, may have a commission when they are bought and sold.

On the page you are on, look down the left hand side, find "Holdings," and click.  This will bring you to:

Source: Yahoo

CLICK IMAGE TO ENLARGE  You surely recognize some of the names on this list.  Also, you are probably not surprised that Apple Inc. is the largest holding percentage-wise on the list.

As an exercise, you want to find the P/E ratio of the stocks.  The P/E ratio is a measure of how much you pay for a dollar's worth of earnings. Think about this, and you'll see that it is a neat way to compare stocks.  It gets you to start to think about why you would pay more for a dollar's worth of earnings for Apple Inc. than for Kellogg, for example.

So click on the symbol for each stock.  Doing this for Apple Inc. gets you to:

Source: Yahoo

CLICK IMAGE TO ENLARGE

As you can see, the P/E for Apple Inc. is 18.11. This means that if you buy AAPL at the price shown, you would be paying $18.11 for a dollar's worth of earnings.  You can actually check this because you have the earnings and price on the same page.  Divide 636.23 by 35.14. By the way "ttm" stands for "trailing 12 months."

As you become more sophisticated, you'll learn that there are different ways to calculate P/E.  For example, some analysts prefer P/Es based on predicted earnings.

For now, it would be a great exercise to do what we did for the other top holdings in XLK.  You'll find the P/E for IBM is 15.69 and then start to wonder why investors pay more for $1s worth of Apple Inc. earnings than they do for IBM's earnings.  Now you are on the path to stock analysis.

If you need another sector, check out XLE.  This is the energy sector of the S&P 500.  For homework, find out the P/Es of the top holdings in the energy sector.  It would also be worthwhile finding the historical prices of XLK.  For example, find where it was on this date last year; and calculate the percentage change in its price as we did yesterday for the S&P 500.