Sure, you've heard the age-old buy low, sell high, but what does that really mean?

When is a stock's price considered low? $10 a share? $100? There's no perfect answer to these questions, but there are ways to at least gauge how expensive or cheap a stock is.

You see, by using something called a multiple, we can figure out how much we're paying for a stock's underlying business, and if this price has changed over time.

Interested? We'll dive into the topic and more on today's Plain Bagel.

You may have noticed that when you Google search a stock, like, well, Google for example, you end up with a series of search results, as well as some basic details about the ticker.

In there, you have your stock's open price, market capitalization, and dividend yield, but it also lists something called the P-E ratio of the company.

The P-E is an example of what's called a multiple, a ratio that compares a stock's price to some fundamental number. Generally speaking, the higher the multiple, the more expensive a stock is considered. Think of it as like a price per pound at a butcher shop.

In shopping for pork, beef, or chicken, it's difficult to compare the total prices, since the quantity you get is different for each cut. But if you look at the price per pound, you can easily figure out which cut is the best bang for your buck.

Multiples work in a similar way, allowing us to compare the price of a stock to the underlying fundamentals you get with the purchase. Now, there are hundreds of different multiples that investors can use, including the EV to EBITDA, price to book value, etc, etc.

Some of the multiples are industry-specific, whereas others are more broad in nature, and each carries a different implication. But the P-E ratio, which stands for the price-to-earnings ratio, is one of the most straightforward and popular.

It's easy enough to calculate, since you take the stock's price and divide it by the company's earnings per share. For example, if Plain Bagel Co. had 1 million shares outstanding, each of which were trading at a price of $30, and last year their net income was $2 million, the stock's P-E ratio would be 15 times. This P-E ratio is known as a trailing P-E, because we're calculating it using historical information, and it's one of the easiest multiples to understand. It basically represents how much an investor is willing to pay per dollar of a company's profits. So for Plain Bagel Co., we are paying a price equal to 15 times our share of the company's profit. So the trailing P-E helps conceptualize how much we're paying for a stock, but it does have its shortcomings. The biggest one being that it is backwards-looking, whereas many believe that markets are forward-looking. If a company is expected to release a new product, enter a new market, or improve its operations in the future, then a stock will likely trade higher, something that the trailing P-E wouldn't take into account using past earnings to explain the stock's current price. Because of this, many investors prefer instead to use what's known as a forward multiple, in this case the forward P-E, which divides a stock's price by how much the company is expected to make next year.

For example, let's say that Plain Bagel Co. is expected to launch a new bagel product next year, and as a result, analysts are expecting earnings to increase to $2.5 million next year.

In this case, assuming everything else remains unchanged, Plain Bagel Co.'s forward P-E multiple would equal 12 times. Now, the clear problem with forward multiples is that they rely on forecasts, which may not pan out, but they can still help gauge the value of a stock and how much investors are paying up for a company's potential profit. So for Plain Bagel Co., our forward-looking P-E is 12 times. Great, but what does that mean? Well, by itself, not a whole lot. You see, multiples are a relative measure. Sure, understanding how long it will take for your stock to pay for itself is useful, but to understand whether the level is attractive or not, we've got to compare it to other multiples. We could, for example, compare the P-E ratio to Plain Bagel Co.'s historical P-E ratios to see how it has changed over time. This would give us an idea of whether investors are valuing the company higher or lower than normal.

If the company's earnings are expected to increase, but the price of the stock has fallen, it would mean that the multiple has contracted, and investors don't value the profitability of the firm as much as they used to. Alternatively, if earnings are falling but the price has risen, well, the multiple has expanded, meaning people are paying more for less profit.

We could also compare the P-E multiple to the stock's long-term average to see whether the margin is larger or smaller than normal. If the stock's 10-year average P-E is 15 times, we could assume that the stock's multiple is temporarily cheaper than normal, and may warrant a buy. If we pick up the stock and the multiple later expands back to its long-term average, then we could earn a return, even if the company's earnings are flat.

A key assumption here is that a multiple is expected to revert to its mean over time.

And while that doesn't always hold true, investors sometimes look for extreme variations from the mean, with many believing that short-term volatility in a stock's multiple, which could be caused by a bad press release or negative near-term headwind, will eventually subside, causing the multiple to return to its normal level, assuming the company's core business remains unchanged. Awesome, so if I find a company that's trading at a multiple below its historical average, I'm good to buy, right? Well, not quite. Sure, understanding where the company's stock value stands relative to its past is great, but you need to compare the value to other stocks as well, in the same industry. In our analogy, if you found pork on sale for $6 a pound, it may still be too expensive if a butcher down the road is offering pork for a regular price of $2.50 a pound. Similarly, we need to gauge the value of a stock relative to its peers.

So, let's take Plain Bagel Co. and compare it to Sesame Sands and The Haggle Bagel, which are trading at 4 PEs of 13x and 7x, respectively. If you compare Plain Bagel Co.'s 12x multiple to its peer average of 10x, well, then we can see that the stock is actually more expensive than other bagel companies on average. Alright, so the stock is cheaper than it normally is, but more expensive than its peers, so should I buy or sell or what? Well, as great as it would be to have a one-number basis for making investment decisions, it's simply not that simple.

Multiples are limited in the amount of insight they provide. With the PE multiple, for example, we aren't taking into account the company's growth rate. Sure, compared to peers, Plain

Bagel Co.'s PE of 12x may seem expensive, but if Plain Bagel Co. is also growing its earnings at a faster pace, the multiple may be justified. This is why high-growth companies, like those in the tech space, tend to have higher multiples than stocks in slower-moving areas, like utilities.

On the other side of the spectrum, just because a company is trading at a PE below its peers, or even below its historical average, doesn't mean it's a good buy. The multiple compression could be justified if the company's fundamentals have deteriorated. What do I mean by that? Well, let's go back to our analogy. Imagine you're at the butcher shop, and you see two steaks trading at $10 a pound and $3 a pound. Looking for some value, you pick up the $3 cut, but when you get home, you find that the steak you bought has expired, and that it's a lower-quality cut, and you're not even sure if it's actually beef anymore. So, aside from learning that there's something wrong with a $3 steak, what's the lesson here? Well, just because something is cheap, doesn't mean you should buy it. A lower stock's PE may reflect a justified devaluation of the company. Maybe for the Plain Bagel Co., keto diets are expected to kill the bagel industry.

Or maybe the company is facing regulation that will prevent it from making its staple plain bagel.

These are things that would hurt Plain Bagel Co.'s future profitability.

And even though the multiple would contract, it doesn't make the company a good buy.

Because the company's core, long-term prospects have deteriorated. That's the thing about multiples.

They are pretty meaningless without context, and chasing low multiples without an understanding of a company's core business and future prospects may leave you with something called a value trap.

A stock that looks cheap compared to its historical prices, but continues to fall even further because of a deterioration in the firm's fundamentals. So, why discuss multiples if they could mean that a stock is both over and undervalued? Well, it's not that multiples are useless.

They are a handy way to quickly understand a stock's price level. But, as I said at the beginning, they are a rough gauge of a stock's value at best. Some investors even contest that the PE multiple is incredibly limited because of its use of accounting earnings numbers, which may be easily altered by management assumptions and non-cash items. So, while multiples can certainly help you make investment decisions, you need to ensure that your decision is based on a thorough understanding of a firm's operations and future prospects, not just the stock's multiple. A good approach is to find companies you like based on their fundamentals, and then find some appropriate multiple to understand the firm's valuation after the fact. Looking for cheap stocks first may leave you with a portfolio of low-quality holdings. After all, as Warren Buffett says, it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. So, next time you find a stock trading at a low multiple or a stake selling at $3 a pound, make sure to check the fundamentals, and the stake's expiration, and that the stake is actually a stake. But, with that said, we're out of time.

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If you have any feedback or topics you'd like us to cover in future videos, leave a comment down below. For The Plain Bagel, my name is Richard Coffin. Thanks for joining me today.