The Daily Technical #11

Good morning. Welcome to the 11th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Intuitively, what does the P/E ratio mean?

The P/E ratio, or price-to-earnings ratio, tells you exactly how much the market is willing to pay for each dollar of a company’s earnings. In other words, it's a quick gauge of a company's valuation. Here’s how to nail your answer:

First, remember the basic formulas:

• P/E Ratio = Current Share Price / Earnings Per Share (EPS)

• Or equivalently, P/E Ratio = Market Capitalization / Net Income

The P/E ratio is essentially a measure of how expensive or cheap a stock is relative to its earnings. The higher the P/E ratio, the more “expensive” the stock is considered because investors are willing to pay more for each dollar of earnings. Comparing a company’s P/E ratio to its industry average and peers can highlight whether it’s overvalued, fairly valued, or undervalued.

Suppose Company A has a share price of $100 and an EPS of $5. The P/E ratio is 20. This means investors are willing to pay $20 for each $1 of earnings. If the industry average P/E is 15, Company A might be seen as overvalued unless it has higher growth prospects.

Common Mistakes

1. Forgetting Context: A P/E ratio without context isn’t very useful. Always relate the P/E to market or industry benchmarks.

2. Ignoring Growth Rates: High P/E doesn’t always mean overvaluation. Sometimes it reflects higher expected growth rates. Failing to consider this can lead to misleading conclusions.

3. Mixing Metrics: Don’t confuse P/E ratio with other valuation metrics like P/B (price-to-book) or P/S (price-to-sales). Each serves a different purpose.

Key Takeaways / TLDR

• P/E Ratio = Current Share Price / EPS

• It shows how much the market values each dollar of earnings, providing a snapshot of relative valuation

• Compare it with industry averages and peers for meaningful insights

TODAY’S QUESTION
What are some of the most common reasons that M&A deals fail to create value?

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