When seeing a £200 jacket in a shop while you can buy a different one for just £50, you might wonder, “Why is it so expensive? What’s so different about it?” If you later discover that the £200 one is ten times better than the £50 one, would you still think it’s expensive? You see, there is a difference between “expensive” and “overpriced”—overpriced means unjustified.
Different from shopping at Decathlon, where you look at the price tag and decide whether you are satisfied, shopping at the equity market is a bit more complicated, since an equity priced at £200 is not necessarily more “expensive” than one priced at £50—this is why we need price multiples.
You might not know what price multiples are exactly, but you might have heard of terms like price-to-book (P/B) or price-to-earnings (P/E) ratios if you are interested in the equity market. All these ratios involving share price can be called price multiples—some other common price multiples are price-to-cash flow (P/CF) or price-to-sales (P/S). These multiples act as price tags of equities.
You might say, “That’s more than the price tags they put on at TK Maxx. Which one do I look at?” First, not all these multiples will be available as some companies don’t have positive earnings or cash flow figures. Second, some multiples might be irrelevant depending on the company or industry we are shopping for. For example, the P/B ratio measures the price we are paying for a company’s net asset, but the assets of some companies with a long history could have been on their balance sheet for over a hundred years, which means the asset value is no longer relevant. Plus, we as equity investors like profit-generating companies, not asset-purchasing companies—we don’t purchase equity to count on asset liquidation events.
With that said, let’s look at the equity share of Advanced Micro Devices (NASDAQ: AMD). AMD closed at $123.85 on Wednesday, 29 November, which indicates a trailing-12-month P/E ratio of 519. Is 519 too expensive? Just as you would compare the price alongside other similar items at a shop, you compare the price multiples with other equities in the market—the P/E ratio of the S&P 500 index is just below 22. Now AMD seems like nothing but a scam.
The problem is, when you buy a coat at, say TK Maxx again, you don’t compare the price of the coat with the average price of everything at TK Maxx—it would make more sense to compare it with the average price of coats only. This is why I found you this Philadelphia Semiconductor Index (SOX), which comprises 30 companies in the semiconductor industry, making it a better benchmark for AMD than the S&P 500. However, the P/E ratio of SOX is 33, still much lower than 519.
The thing is, though 519 obviously implies a huge premium for AMD’s share, it is a trailing ratio, and this is where stock shopping is different: when we buy clothes, we don’t normally count on value appreciation, but as equity investors, we only worry about what happens in the future. Therefore, forward ratios are more important than trailing ratios when shopping for stock.
The forward P/E ratio depends on the forward earnings per share. Although the trailing-12-month earnings per share (EPS) for AMD is $0.24, analysts are expecting a 1-year forward EPS of $3.33 from AMD, which will bring down the P/E ratio to merely 37—sounds immediately better than 519, though still higher than SOX’s P/E ratio of 33. Given that AMD’s earnings growth over the last 12 months is in line with the average growth of the semiconductor industry at 4%, investors have reasons to believe that AMD is overpriced.
When we are shopping for equities the next time, the question we should ask ourselves is: is the price premium justifiable? Just as in clothes shopping, the key is not just comparing prices but also considering the value and future benefits. If a company demonstrates a growth level that outshines its peers, then a price premium for its equity is well deserved. The conclusion? Don’t walk away when you see high price multiples on equity, but do walk away if they are unjustifiable.