1

Would it be valid to assume that a stock with a low P/E ratio and also very high EPS is, generally speaking, a better purchase than a stock with that same P/E but lower EPS?

My reasoning for this is that if EPS is the denominator in the P/E ratio, then a higher denominator means potential future price increases will have less of an upward effect on the P/E than if the denominator was lower. That could mean the stock has more potential upside before it starts to look overvalued, which factors into overall demand.

Of course there are tons of other factors to consider -- but all other things being equal if you have two stocks, both with a P/E of 2, and one has an EPS of 5 whereas the other has an EPS of 10 is the latter a better purchase?

The flipside of this logic that I am wondering about is earnings growth potential. Obviously if EPS is expected to decrease or increase that has important implications. Is it possible that a stock with a high PE and relatively low EPS is a really good purchase if EPS growth is expected? I think I read a rationale along these lines in Burton Malkiel's book but I'm not positive -- since PE is a price-to-earnings multiple, you could look at it this way:

If a stock has a P/E of 8 and EPS is expected to increase $1, then price should actually increase by $8 assuming constant P/E. A similarly priced stock with a lower P/E of only 4 would only increase $4 with the same earnings increase. This is sort of a counter-intuitive attitude towards P/E since a higher P/E could actually be beneficial.

Is it valid to look at valuation ratios this way? The tricky part is that you have to assume certain values remain constant, I suppose.

3

You could not have two stocks both at $40, both with P/E 2, but one an EPS of $5 and the other $10.

EPS = Earnings Per Share
P/E = Price per share/Earnings Per Share

So, in your example, the stock with EPS of $5 has a P/E of 8, and the stock with an EPS of $10 has a P/E of 4.

So no, it's not valid way of looking at things, because your understanding of EPS and P/E is incorrect.


Update:
Ok, with that fixed, I think I understand your question better.

This isn't a valid way of looking at P/E. You nailed one problem yourself at the end of the post:

The tricky part is that you have to assume certain values remain constant, I suppose

But besides that, it still doesn't work.

It seems to make sense in the context of investor psychology: if a stock is "supposed to" trade at a low P/E, like a utility, that it would stay at that low P/E, and thus a $1 worth of EPS increase would result in lower $$ price increase than a stock that was "supposed to" have a high P/E.

And that would be true. But let's game it out:

Scenario
Say you have two stocks, ABC and XYZ. Both have $5 EPS.
ABC is a utility, so it has a low P/E of 5, and thus trades at $25/share.
XYZ is a high flying tech company, so it has a P/E of 10, thus trading at $50/share.

If both companies increase their EPS by $1, to $6, and the P/Es remain the same, that means company ABC rises to $30, and company XYZ rises to $60. Hey! One went up $5, and the other $10, twice as much! That means XYZ was the better investment, right? Nope.

You see, shares are not tokens, and you don't get an identical, arbitrary number of them. You make an investment, and that's in dollars. So, say you'd invested $1,000 in each.
$1,000 in ABC buys you 40 shares.
$1,000 in XYZ buys you 20 shares.
Their EPS adds that buck, the shares rise to maintain P/E, and you have:
ABC: $6 EPS at P/E 5 = $30/share. Position value = 40 shares x $30/share = $1,200
XYZ: $6 EPS at P/E 10 = $60/share. Position value = 20 shares x $60/share = $1,200

They both make you the exact same 20% profit. It makes sense when you think about it this way: a 20% increase in EPS is going to give you a 20% increase in price if the P/E is to remain constant. It doesn't matter what the dollar amount of the EPS or the share price is.

2

all other things being equal if you have two stocks, both with a P/E of 2, and one has an EPS of 5 whereas the other has an EPS of 10 is the latter a better purchase?

What this really boils down to is the number of shares a company has outstanding. Given the same earnings & P/E, a company with fewer shares will have a higher EPS than a company with more shares. Knowing that, I don't think the number of shares has much if anything to do with the quality of a company.

It's similar to the arguments I hear often from people new to investing where they think that a company with a share price of $100/share must be better than a company with a share price of $30/share simply because the share price is higher.

  • Thats a good point, although couldn't you argue that the company with fewer shares, all other things being equal (especially demand), is coveted more because its shares are in shorter supply? It has nothing to do with the quality of the company, but something to do with supply & demand effecting the value of the stock. – Sean Thoman Jan 6 '12 at 23:18
  • @Sean Thoman - what you suggest would be true only if the "demand" is being measured in shares, not in the worth of the piece of the company represented by those shares. This would happen only if people are buying a share as a souvenir or keepsake to frame, and not as a financial investment. As an investment, the demand is for the earning potential of a percentage of the company. The investor is looking to invest his $5000 for a piece of the company that will earn (say) $500 a year, and it doesn't matter if that is represented by 100 shares or 50 shares on the certificate. – mgkrebbs Jan 7 '12 at 2:31
1

Check your math...

"two stocks, both with a P/E of 2 trading at $40 per share lets say, and one has an EPS of 5 whereas the other has an EPS of 10 is the latter a better purchase?"

If a stock has P/E of 2 and price of $40 it has an EPS of $20. Not $10. Not $5.

  • True, I should have left out the price. Fixed now. – Sean Thoman Jan 6 '12 at 19:47

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