If You Buy a Stock at $1 and It Rises To $3, What Do You Do? Sell? Hold? Buy More?! (Understanding PE Ratio)
Jul 19th, 2007 by AhYap
My mum and dad (and a lot of investors) will feel extremely nervous, when the stock they bought rise from $1 to $3.
What they are thinking is, “Should I sell! Should I take the profit? Will it rise more? What if I sell and it rise more? What if I didn’t sell and it drop back to $1?! Or $0.50!!!”
They scare that their profit will be vanished if they don’t sell now. Or even worst, lost their initial capital. They believe that they still haven’t really make the $2 until the sell. They feel that the $2 is in a risky position that can be gone if the price go down.
People get an idea of something by comparing it to something else. (remember my post on politicians play the compare game?) It is something similar.
What does 100kg means? It means nothing unless you know what context to compare it. When we are talking about human weight, we will need to compare 100kg with other human weights. In this context 100kg is someone with a FAT ass. 100kg is very heavy. But if we are talking about dinosaur, 100kg might just be its fat-little-dick (Oh!). 100kg become very little.
Now, when somebody bought a stock at $1 and he knows nothing about the underlying business, the only thing he can compare with is his buying price! So if it goes up to $5, he compare it to his buying price of $1 and think that his stock is very expensive now and he should consider selling. If it goes down to $0.50, he also compares to the $1 and feel that his stock has gone to hell.
If you do that, you have compare the price with the wrong thing. The whole context and perspective are wrong. For the very same stock, it can be very expensive when it is $1 and it can be extremely cheap when it is $10.
The right thing to compare is not your buying price or historical price. The right thing to compare is the EARNING of the business! How much you are willing to pay for a business depends on how much money the business is making (and will be making)!
Let’s say you own a petrol station and you want to sell it. Your petrol station will make a steady earning of $200,000 per year. How much do you want to sell it?
Will you sell it for $200,000? If you will, you need to jump off from KLCC. Your petrol station can make $200,000 per year and 5 years it will make $1 million and the money you can make is basically infinite and forever (unless your petrol station is hit by a meteor and exploded). It is a money printing machine. Only idiots (sohai in our language) and gamblers who owe money to Lim Goh Thong (the Boss of Genting Casino) will sell it at $100,000.
So what is the right price to sell? You are selling something that is depositing a fix amount of money to your bank account every year. To make sense, you need to sell it for a few times that earning. That means instead of waiting ‘slowly’ for $200,00 once a year, you are willing to sell it to somebody who will pay you in advance a few years of the future earnings. Say 5 years, it will be $1 million.
You receive $1 million in your bank account today, 5 years of your future earning. By taking that money in advance, you give away your rights to the petrol station. The business has nothing to do with you anymore no matter how much it make in the future. The buyer, on the other hand has taken the company from you. He will be able to collect back his initial investment capital of $1 million 5 years from today. After that, he will be making real money that is not his initial capital.
How many times the earning you are willing to pay create a ratio called the Price Per Earning Ratio. We called it the PE ratio. In the petrol station case, the earning is $200,000 and the price sold is $1 million. So the PE ratio is 5.
PE is very meaningful when we are referring to a healthy business that is consistently profitable, such as Public Bank, Digi, etc. They all have stable earnings (the E) and a quoted price everyday from the stock market (the P). With the E and the P, we can easily get the PE, that’s how many times people are currently willing to pay for the earning.
Today DIGI’s PE is 21 while PBBANK’s PE is 19. So if you buy DIGI today, you are willing to pay 21 times the current earning of DIGI.
Let’s go back to what I am talking at the beginning. Why people are comparing to the wrong thing and why $1 can be more expensive than $10.
From our very first example, you pay $1 for a stock and 3 years later it goes to $3. You become very nervous and keep asking yourself, “Should I sell? Should I sell?”.
Read This Carefully -> You don’t compare the current price with your buying price or historical price because the situation of the business today is very different than the situation 3 years ago!
When you bought at $1, the company might be making 10 cents per share (PE 10). 3 years later, the business grows and it might be making 30 cents now. The PE is still 10! So why do you need to be so worry about your $1 investment that now become $3? The value of the company has increase the same time when the price of your stock increase. Both has increased equally in this scenario.
REPEAT -> Compare the current price to the earning, not your buying price or historical price!
Let’s make it more interesting. Instead of making 30 cents per share, the company is now making 60 cents! The PE is now 5! It is actually cheaper at $3 now when it was $1! Why? Because when you bought it, you were paying $1 for $0.10 (PE 10). If you buy it now, you are paying $3 for $0.60 or $1 for $0.20 (PE 5)! You are getting a bargain here.
Why the heck do you need to sell it if you can see the correct picture here? If you have money, you should actually BUY MORE! If you are comparing to your $1 entry price, you will think that I am crazy if I ask you to buy more. But after you know you need to compare the price to earning (the right thing) instead of your buying price (the wrong thing), BUY MORE make a lot of sense now!
Let’s stuck more knowledge into your brain.
A stock that is selling at ALL TIME HIGH doesn’t mean it is expensive. A stock that is selling at ALL TIME LOW doesn’t mean it is cheap. When you are using the word ‘ALL TIME’ you are comparing it with the historical prices. Mistake. A company that is selling at ALL TIME HIGH might also have Earnings at RECORD HIGH so it justify the price. In our previous example when the stock is selling for all time high of $3 but is making a record earning of $0.60 per share, it has actually become cheaper (not more expensive!).
Understanding this let you know that buying at all time high is not stupid and is not risky (given that you have do your homework). It also prevents you from jumping into a sinking Titanic when it is all time low (MEGAN!). Remember, all time high doesn’t mean it is expensive. All time low doesn’t mean it is cheap. You need to compare it to the underlying value, not the historical price (also known as the chart!).
So the answer to the question. “If You Buy a Stock at $1 and It Rises To $3, What Do You Do? Sell? Hold? Buy More?!” should be very clear to you now. What price you buy, has nothing to do with your decision. It is the current earnings and future earnings that are the primary factor to consider.
I think this is a very important thing to know if you want to invest in the stock market. If you know this, I assured you that you are already better than 80% of other investors (They should be called speculators). Uncle aunties who didn’t know this is acceptable. But there are a lot of educated people who work as knowledge workers who didn’t know this at all! That is very disappointed.
Knowing the idea of PE is a good start to your investing journey. But don’t expect it is that simple. What I have explained here is an extremely simplified version. There are still a lot of things that you need to know. For example, if the E of the PE is fake, PE is meaningless. For example, Megan has a PE of 2 when it is selling at $0.60. But later they find out the E is fake. There is no E! It is negative! You can’t even get a PE from a negative E. The same goes to Tranmil that has a fake E. PE become meaningless.
(Megan was selling for only $0.60 for a long time, it is so cheap because PE is only 2! But it ends up that the E is actually fake! Hokkien will say, “Jia Lat Lor!”)
There are a lot more. For example, a construction company can make a lot of money when doing a big project such as building the KLIA. The company can make nothing after that. So the E can be very big when they are working on the project but 0 when the project is over. PE become unreliable if the future is unclear.
As a conclusion, comparing the current price with your buying price or historical price is wrong because businesses do change with time. Current earnings and the future earnings are what you need to compare it with.
This is oversimplified explanation but still serve as a good standing point. The current averaged PE for all the KLSE stocks is around 17.
Next post I will tell you why some company sell more than averaged PE and why some sell for less.