New Year’s Resolution: Financial Independence [Part 6]

Posted By Mark Kaelin

BreakingModern — Just because a single share of a particular stock sells for over $200,000, or over $500, or over $100 does not mean it’s actually expensive when compared to other stocks. In fact, it’s entirely possible that a $200,000 stock is actually much less expensive than a stock selling for a dollar or less.

It’s a common mistake made not only by novice investors, but by some experienced investors as well. However, if you want to achieve financial independence by being smarter than other investors in the market, this is the concept you must understand and embrace.

Price to Earnings Ratio

The market price of a stock is not the number a successful investor uses to measure the value of a stock. A stock’s value is best measured by the Price to Earnings Ratio (P/E), which is calculated by dividing the market price of a stock by its annual earnings per share.

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An example may help to explain. At the time of this writing, Berkshire Hathaway (BRK.A) is trading at a market price of 228,615.00, but its P/E ratio, called its multiple, is about 18. On the other hand, Netflix (NFLX) is trading at $343.68 with a P/E multiple of about 91. That means on a price to earnings ratio basis, Netflix is five times more expensive than Berkshire Hathaway, even though the market prices between the two are hundreds of thousands of dollars apart.

Note: Each publicly traded company’s P/E ratio can easily be found on free financial websites like Yahoo Finance or Google Finance.

Apples and Oranges

This is where investors often lose their way when deciding between stocks. The market price is not nearly as important in your investment decisions as the price to earnings multiple. By doing the minimum of research, investors can compare any stock to any other stock by comparing the respective P/E multiples. The P/E ratio means investors can compare the proverbial apples to oranges or, even better, compare individual apples to the full apple tree.

By comparing their respective multiples, you can compare Microsoft to Apple, for example. But you can also compare Microsoft and Apple to the entire technology industry. This is a very powerful tool that every successful investor must understand and apply to their decision-making process. By using the P/E ratio, each stock, regardless of market price, is given a common measurement for comparison purposes.

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The Ultimate Tool

I cannot emphasize this fact enough — successful investing in the stock market means that you must stop comparing the market price of stocks and start comparing each stock’s P/E ratio. By applying this tool, you immediately become a smarter investor.

Of course, most of us are not going to be able to buy a stock with a trading price of over $220,000, but that is not necessarily because that stock is expensive compared to the rest of the market. It’s really because it is expensive compared to the size of our investment account. The key to investing success is to understand the difference.

Is there a financial concept or general question you have? Drop me a comment and I will do my best to answer it. Check out the articles I’ve written on how to start controlling your finances:

For BMod, I’m Mark W. Kaelin.

Note: The information provided is not intended to provide tax, legal, insurance or investment advice. Risk is an integral part of any investment strategy, and you should consult an attorney or tax professional regarding your specific legal or tax situation.