P/E And P/S Ratios

| April 30, 2008 | 0 Comments

As an investment banker I traveled extensively.  I had the opportunity to work in countries as diverse as Taiwan, Singapore, Great Britain, and France just to name a few.  During my travels I loved nothing more than meeting people from those countries.  While we may have spoken different languages, the language of business was always the same no matter the location.

I met many successful entrepreneurs and more fund managers than I can remember.  But what I do remember are the extensive discussions about company valuations.  Not only what our business was worth but what others were as well.  A great debate always rose up when we started discussing similar companies in different countries.

Not all valuations are the same.

What we discovered was somewhat unusual.  A company on the German DAX Exchange might have a greater value than a similar company on the London Exchange or even the New York Stock Exchange.

Obviously understanding this valuation dynamic is important.

I learned quickly that professional investors looked at companies all over the world when determining the value of a particular company.  And this information and knowledge was . . . well . . . valuable.  But, as the famous saying goes, “value is in the eye of the beholder.”  Nowhere is this more true than in the stock market.

Let me give you an example . . . Airlines.

It’s no secret that I hate airlines.  I think the industry is the worst in existence.  Companies can be crushed by any industry issue and there are many issues:  High fixed costs, extensive (but needed) government regulation, high labor costs, and unpredictable revenues.  And don’t even get me started on the constant price wars, aggressive competition, and exposure to volatile commodities like oil and jet fuel.  All together these variables provide a recipe for failure.

So why do I watch the airlines?

I hate the industry but I think a smart trader can make money trading the airlines.  One key to success is following the industry and monitoring the ratios that have some importance.  For the airlines I’m going to focus on two key ratios:  Price to Earnings (P/E) and Price to Sales (P/S).  You’ll see why in a moment.

In the airline industry there are a number of major players.  United (UAUA)American (AMR), Delta (DAL), Northwest (NWA), and Southwest (LUV).  I know there are several others but let’s keep this simple.

As of right now, their ratios are:

United P/E – 54.1x P/S – 0.09x
American P/E – 21.8x P/S – 0.09x
Delta P/E – NA P/S – 0.17x
Northwest P/E – NA P/S – 0.19x
Southwest P/E – 17.1x P/S – 0.96x

Now don’t get flustered by these numbers.  I pulled them right off of Yahoo! Finance where anyone can go and find these financial ratios and many more.

The first ratio I want to look at is Price to Sales (P/S).

The reason I started with this ratio is simple.  I think it’s meaningless. The average ratio in this group is .3x. and the range is from .09x to .96x a difference of more than 10 times!  Because the airline industry brings in billions of dollars in sales, the ratio is diluted.  Delta’s ratio is almost double the United ratio . . . but what does that mean?  A change in these ratios ultimately won’t tell you much.

The key here is to make sure you use the right ratios and that the numbers make sense.

The other ratio to look at is Price to Earnings (P/E).

When you look at these different airlines you’ll notice something interesting.  Every company has a different valuation and some have none at all.  As we know, P/E ratios compare a company’s stock price to its earnings per share.  If a stock doesn’t have a P/E ratio the company doesn’t have earnings.  We all know that’s no good.

Look at United’s P/E ratio of 51.1x and Southwest’s ratio of 17.1x. Knowing what you do about the industry, do you really think United should be worth more than Southwest?  Almost 3 times more?  I mean really.  Southwest consistently generates profits year after year and United . . . well, not so much.

Looking at these ratios I would conclude that United is overvalued and Southwest is undervalued.

And this leads me to my final tip when using ratios.

Understanding the “Why” behind the numbers is much more powerful than just noticing the differences.  This is where your due diligence and research come in handy.  Over time you will start to notice trends in the ratios.  And it’s those trends that’ll help you trade for profits in an otherwise horrible industry.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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