314 | Is My Company's Stock Overpriced? | P.E. Ratio Explained

Apr 19, 2021

Ask episode

Chapters

Transcript

Episode notes

The Households of FI series continues! In this episode, we touch base with Kristi, the single mom from Minnesota who. New to FI, Kristi is working to get on the path but has questions about her company's Price-to-Earnings (P/E) Ratio and the Employee Stock Purchase Plan (ESPP).
How to evaluate what a company's stock is worth is not something many of us index fund investors know a lot about, but it's good to be familiar with it. Individual stock selection is something that Brian Feroldi gets excited about, making him the perfect mentor for Kristi and her ESPP questions.
The only individual stock Kristi owns is her company's stock. She is able to buy her company's stock for a 15% discount with up to 10% of her income.
She has been buying this stock since beginning her career six years ago and has accumulated a lot of it. Because she didn't know anything about investing prior to finding the FI community, she nows calls this her biggest financial mistake and has finally started selling a bit of it.
She originally thought that sell the stock with the lowest cost basis to realize the largest gain would be the best strategy, but now questions if that is the best move.
Brian says a lot of publicly-traded companies offer ESPP, like Kristi's. Company plans vary somewhat, and it sounds like her company purchases lots of the stock on a monthly basis at the end of the month.
As long as Kristi holds the stock for two years, the 15% discount is taxed as ordinary income, and capital gains are taxed as long-term capital gains.
Discounted stock sounds like a great deal, but Kristi has a lot of risk tied to her company. Her salary, bonus, retirement plan, benefits, and career capital all rely on the company. Purchasing employee stock increases the risk even more.
When Brian started his career, his company offered an ESPP, and although he was bullish on the company, he chose not to participate as a risk management strategy. He already had too much riding on the companies success to risk adding to it.
Although the company did well and he would have increased his wealth, he is happy with the choices he made because he was maximizing his potential net worth, while assuming as little risk as possible.
Although her company is a blue-chip business and low-risk company. Kristi will need to ask herself how much risk she wants to be tied to it.
Brian says ESPPs are great, but you'll want to make sure you are taking care of everything else first, such as an emergency fund, 401K, debt, and IRAs.
Although her company is the only individual stock she owns, she is somewhat interested in owning other individual stocks. She can add that in over the top of the bulk of investments in index funds, while remaining diversified, and still feel good about her long-term compounding chances.
Kristi would like to know how to evaluate an individual company's stock for investing in the short-term and long-term. She knows the P/E ratio is something to look at and her company's P/E ratio is 18.66.
Brian says a P/E ratio is a tool you can use to evaluate stocks, but it's important to know when it is appropriate to use and when it is not.
First, Brian says he never invests in a company short-term, or less than three years because it's impossible to know what a stock is going to do in the short-term. Long-term stock prices are driven by earnings power and earnings growth which is the company's profitability.
In P/E ratio, the P stands for price or the price of one share. E stands for earnings, the net income or profits per share. The difference between those two numbers is the price investors are willing to pay for $1 profit in the company.
With Kristi's company, for every $1 in earnings power generated, the market is willing to pay 18.66 times that number.
Brian says it's helpful to flip that number around and think about it as an interest rate. Take 100 and divide it by 18.66, to get 5.35% on the company's earnings power. But is that good or bad? Context is key.
When looking at over the last decade, Kristi's very stable company's P/E ratio varied from 30 to 12. Since the current P/E ratio of 18.66 is on the lower half of that range, Brian says the stock is more likely to be in bargain territory than it is to be overly expensive.
Next, Brian pulls up the company's net income over the last decade, which has been mostly stable with a few spikes and other periods when it has fallen. This needs to be compared to the P/E ratio as the highs and lows may be artificial.
Another metric Brain says to look at is the price-to-sales ratio, which is the price of the business divided by the sales, or revenue per share. This ratio eliminates the one-time swings and tends to be much more stable. Over the last decade, her company's ratio varied from 5 to 2 and is currently at 3, again leading Brian to believe the stock is in buy territory.
If you have an ESPP, you want to look at the minimum holding period, know when you are outside the short-term capital gains, and the other details of your company plans. Consider rolling it over to an investment outside your company once the plan requirements have been met and it meets long-term capital gains requirements.
Long-term capital gains have preferential tax rates. The line of delineation between short and long is one year.
Investment gains are not subject to tax until they are realized. If selling an investment held less than a year, the gain will be taxed as if it was ordinary income, or whatever your top marginal tax rate is, which for most is 20-24%.
Gains from investments held longer than one year are as taxed as long-term gains, which for most people is 15%.
For those who have access to an ESPP, it is part of your compensation but will require a bit of research because there is some risk in tying up so much of your wealth into one company.

Resources Mentioned In Today's Conversation

If You Want To Support ChooseFI:

Earn $1,000 in cashback with ChooseFI's 3-card credit card strategy.
Share FI by sending a friend ChooseFI: Your Blueprint to Financial Independence.