Syeda Seirut Javed
5 min read
When looking at stock market tickers, it is easy to fall into the trap of judging a company by its absolute dollar price rather than what is actually being paid for its earnings. During the September 2 episode of Mad Money, Jim Cramer tackled the misconception by comparing two completely different tech players, including hardware and flash storage giant Sandisk Corporation (NASDAQ:SNDK) and enterprise software leader MongoDB, Inc. (NASDAQ:MDB). He stated:
Unfortunately, many people are like my late mom, who looked at stock prices, I guess you’d call it, in a vacuum. As mom saw it, disk drive maker Sandisk with a price of $1,553 would be considered far more expensive than enterprise software company MongoDB at $375… All these companies have different numbers of shares. They have different earnings per share. So where the stock’s trading, it’s a pure abstraction… Really doesn’t tell you much at all. Now, if you want to truly compare them, be able to figure out what’s expensive, what’s not, you need to figure out what the companies are supposed to earn for the next 12 months, readily available at almost any stock site, then you divide the stock price by the earnings, and you get something called the price to earnings multiple.
Comparing PE multiples is the apples to apples way to value one stock versus another. Or maybe you want to think about it algebraically. You want to figure out the M. You divide the stock price, P, by the earnings estimate, E, or P divided by E equals M. When you’re valuing a stock, you’re solving for M. And M is the secret sauce behind everything in this business.
Let’s look at it in action. You’ll understand. Sandisk is supposed to earn $212 a share. You divide the price of the stock by that estimate and you get a price to earnings multiple. Comes out about 7.3. Considering the average stock in the S&P sells for 21 times earnings, that’s a steal. Enterprise software company MongoDB on the other hand is supposed to earn just under $6.50. You divide that and the stock price and you get an M of nearly 58. Sandisk’s trading at 7.5 times earnings. See, that’s a heck of a lot cheaper than MongoDB trading at almost 58 times earnings. No wonder the latter plunged 13.5% today after a decent quarter. It’s too rich in this market, and too rich equals sell… MongoDB is a really good company but its quarter wasn’t perfect so it got killed.
Looking Past Nominal Share Prices
When evaluating investments, looking only at the dollar amount on a ticker can trick investors’ brain. Comparing a high nominal share price like Sandisk Corporation (NASDAQ:SNDK) trading above $1,500 to a lower absolute price like MongoDB, Inc. (NASDAQ:MDB) sitting at $384 could be considered a rookie mistake if investors ignore share counts and earnings. Nominal price is just a number in a vacuum that does not reveal much about whether a business is actually a good deal. To make smart choices, investors must look past the surface ticker and focus on what the business generates in profits.
