How To Measure Risk In Stock Market Investments

One of the best ways to track and measure your risk in stock market investments is to follow the P-E (price to earnings) ratio of both the overall market and (if you buy individual stocks) the P-E for those stocks as well. This is one great way to start making better investment decisions.

What is The Price Earnings Ratio?

The P-E ratio is a number that tells you how optimistic or pessimistic investors are. The higher the number, the more optimistic investors are as you’ll see. No matter how awesome your investment strategy may be, it always pays to know which way the wind is blowing friend.

You can get the P-E number on the net pretty easily at any number of finance sites as well. It’s calculated by taking the current market price of the stock or index and dividing it by the annualized earnings. Let’s look at a couple of hypothetical examples in order to give you a sense of how this works.

Let’s say a stock is trading at $180 per share but when you take all the earnings it made in a year and divide it by the number of shares that are outstanding, it only earns $4.50 per share. The PE ratio in this case is 40. Again, it’s calculated by dividing $180 by $4.50. This means investors are willing to pay $40 in stock price for every $1 this company earns. Now let’s fast forward 5 years.

Let’s say the stocks now trades at $450 a share and the earnings have exploded to $45 per share. That means the P-E ratio drops to 10. In other words, investors are now only willing to pay $10 for every $1 of earnings this company makes.

Why were investors willing to pay $40 for every dollar earned 5 years ago and now they are only willing to pay $10? The reason for this is because 5 years ago people were super-optimistic about the future for this particular company. Maybe they read something exciting in the shareholders’ letters and thought earnings were going to skyrocket. As a result they didn’t mind paying a great deal for the stock based on the earnings at that time. They expected to see big things with respect to future earnings and as it turns out, they were right.

But based on this example, current investors are now more cautious. They are willing to pay 75% less per $1 of earnings because they are less optimistic about the future. If you don’t buy individual stocks, you can watch the PE of the S&P 500 to gauge the overall optimism or pessimism as well.

By the way, can you guess which company these numbers closely resemble? If you said “Apple” you were right!

Why is the PE Ratio a Risk Measurement?

Below is a graph showing the P-E ratio of the S&P 500 dating back to 18XX. You can see that the P-E ratio is all over the map. That’s because sometimes the “P” fluctuated wildly and sometimes the “E” did. Let’s see how to use this information to gauge risk.

If the earnings are more or less stable but the “P” or “Price” goes through the roof (or through the floor) it means something has shifted with respect to the market sentiment. That means investors might be getting too optimistic or pessimistic about the future. Think about a stock that earns $10 per share and trades for $100. If the earnings remain at $10 per share but the price shoots up to $1000 per share, that means investors are super excited about future prospects. The P-E went from 10 to 100 overnight. They could be right of course but without the earnings to back it up soon, the stock trading at the P-E ratio of 100 is much riskier than it was when the price was $100. Right?

Now let’s consider an alternative situation. Let’s say that same stock that used to trade at $100 and earn $10 per share suddenly strikes gold and starts earning $50 per share. The P-E ratio becomes 2 at that point and it’s a good bet that the price of this stock is going to climb.

You can see that the P-E ratio of stocks and the overall market helps you get a sense of how much risk you might be taking with your investments. Mainly, when the price moves without a corresponding shift in earnings – beware.

How do you measure the risk in your investments?