One Metric You Need to Know to Make Sense of a Stock's Price

The simple price of a stock can reveal a lot of information, but there's plenty missing from that number.

In this clip, Gaby Lapera and John Maxfield explain what the P/E ratio is, how investors can look at it to ascertain risk and speculation levels, why some companies have astronomically high P/Es, and how to use the figure to get an idea of whether or not a stock's price is fair.

A transcript follows the video.

This podcast was recorded on Feb. 2, 2016. 

Gaby Lapera: So, the other kind of aspect to share prices is -- we covered the global economy, we covered internal things. Sometimes, share prices are higher than the book value of the company because people see enormous room for growth. And we're really talking tech stocks here, that's something that happens a lot with them. So, for example, Amazon.com (AMZN -1.11%). Right now, we looked it up this morning, its P/E was 462 this morning. Correct?

John Maxfield: Yeah, I think that's what we saw. It was a pretty big P/E.

Lapera: That's huge! That's so much! What's a typical one for a bank? 18 or something?

Maxfield: Yeah. I think the S&P 500, I think the average P/E ratio on the S&P 500 right now is 20 or 21.

Lapera: Right. And of course, things vary by industry. But 462 is high, regardless of what industry you're in. But a lot of people see a lot of potential in Amazon, so they're willing to pay a premium for those stocks, despite there not being the present, perhaps, value for them.

Maxfield: Right. And just to clarify one thing, it's not so much that the stocks, their market capitalization are higher than their book value. Really, what we're talking about here is, you're on a continuum, in terms of what you're paying for a stock. And what your P/E ratio tells you -- this is the way you can think about it -- if your P/E ratio is 20, that means you're paying $20 for every $1 of current earnings in that company. So, if your P/E ratio is 5, then you're paying $5 for every $1. So, the higher the P/E ratio, the more speculative the stock.

And in Amazon's case, it's not like Amazon is a speculative company. We're talking about the big four. Gaby, you buy on Amazon, I'm sure, all the time. I buy on Amazon all the time. The issue with Amazon is that their success and their growth and their revenue is not reflected in their bottom line, because what Bezos does -- and Bezos has got to be, I mean, on the shortlist of the best CEOs in the country, and this is one of the reasons -- he's taking all of that money they're earning and he's recycling that back into growth. That's why it's not hitting the bottom line, and that's why their P/E ratio is so high.

Lapera: Yeah. But let's -- you're absolutely right. Sorry, I kind of transitioned into the next thing without acknowledging the fact that you're super right on that.

Maxfield: Did I put you to sleep? (laughs)

Lapera: No! (laughs) I was actually thinking of another tech stock which kind of highlights the risk, perhaps, would be the right word -- GoPro (GPRO -0.56%). When it first went public, its P/E was insane, shares were super expensive, and I have it pulled up on my screen right now, they're currently trading at $11.13 per share, and their P/E is 9.12. So, that's one of the things that you do sometimes see with these companies with these huge P/E values that seem to be a little bit, in terms of stock price, over-valued -- sometimes, they do go down. That is a danger with these.

Maxfield: Yeah. And the other thing -- I think that's a great example, I'm glad you brought their P/E ratio up, because what that also shows us is that, in a case like GoPro vs Amazon, there is much more going on behind the P/E ratio. So, yes, the P/E ratio is a good entry to get a good idea of what's going on, but then you really have to look what's beyond it. In Amazon's case, its cash flow. In GoPro's case, it's -- how I would couch that is, their problem is that they're over-reliant on a single type of product that they're selling.