How much should I pay for a stock? Part 1

Very good question.  This is the essence of investing.  How do I know when I am buying low, and how do I know when I am selling high?  Well, let's get into it...

What if I told you my Apple (AAPL) stock at $125 is cheaper than my speculative Clean Energy Fuels (CLNE) stock at $5.50?  Seems ridiculous, right?  Let's define my usage of the word cheaper.

Obviously, I will pay over $100 more for 1 share of AAPL than I would for 1 share of CLNE.  But there is another important aspect to consider.  AAPL makes a profit and CLNE does not.  In the investing world, we relate the value of a stock to its share price and earnings.  This is called the "Price-to-Earnings" ratio, also known as the "PE ratio," or the "multiple."

We want to learn how to calculate this ratio, but first we need to define a few terms.

Revenues - the amount of money a company brings in by transacting for products and services.  This is also known as "sales" or the "top line."  In terms of lemonade, this is the amount of money I bring in every time I sell a glass of lemonade.  If I sell a glass for $1, and I sell 10 glasses, I have brought in $10 of revenue.

Earnings - the amount of profit a company makes after subtracting the cost of doing business from the revenues.  This is also known as the "bottom line."  I have $10 of revenue from my lemonade sales, but now I need to subtract the cost of my lemons, sugar, water, and cups.  Oh, and I have to pay the tax man.  What I have left is my earnings.

Earnings per Share (EPS) -  Lets say I have $4 of earnings after deducting my costs from the $10 of lemonade revenues.  If we reminisce about getting Joe, Jack, Jock, and Jae to invest in the company, we remember that each of them had 1 share of the company worth $25.  In this case, the total number of shares was 4.  If we want to find the EPS, we must divide the earnings by the total number of shares issued.  

EPS = $4/4shares = $1 per share

If we consider the other example, where each individual purchased 25 shares for a dollar each, we can calculate the EPS again.

EPS = $4/100shares = $.04 per share

Now  we have both parts of our PE ratio.  "P" is the price that the stock is quoted or the price at which you intend to purchase/sell it.  "E" is the EPS.  Let's run this calculation continuing our lemonade example.

For the first example, each share was purchased for $25.  That is our P.  The EPS was $1 per share. Therefore, our PE ratio is $25/$1 = 25. 

For the second example, each share was purchased for $1.  The EPS was $.04 per share. Therefore, our PE ratio is $1/$.04 = 25.

It is no coincidence that these two PE values came out equal.  This example shows that the PE ratio gives us an apples-to-apples comparison tool to use when evaluating all stocks.

Common Sense Take: Take a breather.  We're actually just getting started on this topic.  Check out Part 2 to learn how this apple-to-apples comparison is only sort of an apple-to-apples comparison.