With constant advancements in technology and the wide use of social media, we have access to more financial reading material than ever before (it’s literally at our fingertips). That said, too many opinions and too many perspectives can start to muddy the waters – throw in the usual financial jargon and you’re back to where you started. To help you out, I’ve compiled a few terms that come up frequently, not only in financial literature, but also in the headlines – specifically with respect to the major headliners from this week: Facebook and Amazon.
Market capitalization (or “market cap”) is simply the net worth of a company. Take for example Facebook Inc., who just yesterday posted the largest one-day loss in market value by any company in the U.S. stock market history after releasing disappointing quarterly reports.
If you bought one share of FB today (~174.89 USD), the value of your one share times the number of shares owned by all investors in Facebook equals the market cap. At Wednesday's market close, Facebook's market cap had totaled nearly ~$630 billion but by Thursday’s market close, the social media giant's market cap had plummeted by $119 billion to $510 billion (19% in one day).
No company in the history of the U.S. stock market has ever lost $100 billion in market value in just one day, but two came close: On Sept. 22, 2000, Intel shed ~90.7 billion in market value as the dot-com bubble burst. Earlier that year, Microsoft lost ~80 billion from its market cap in one day. Other companies that have experienced similar one-day losses in dollar amount include Apple in 2013, when it lost ~59.6 billion, and Exxon Mobil in 2008, when it lost ~52.5 billion.
Facebook CEO Mark Zuckerberg personally lost more than $15 billion in stock wealth (a sixth of his net worth, nbd), pushing the 34-year-old out of the top 5 in Forbes’ list of the world’s billionaires (dropping from the #4 spot to #6 with a net worth of $67 billion). Zukerberg now trails Amazon CEO Jeff Bezos ($149 billion), Microsoft co-founder Bill Gates ($95 billion), LVMH CEO Bernard Arnault ($84 billion), Berkshire Hathaway CEO Warren Buffett ($83 billion) and Amancio Ortega ($72 billion), founder of retailing group Inditex, aka ZARA.
Market cap usually comes up when someone refers to a “large-cap”, “mid-cap”, or “small-cap” stock. The definitions change depending on the market and the time period, but right now large-cap stocks in the U.S. have a market cap of around US$10 billion or greater (e.g. Apple, Microsoft, Amazon, JP Morgan, Johnson & Johnson, MasterCard and Exxon Mobile, to name a few, mid-cap stocks are around US$2 billion to US$10 billion (e.g. Harley Davidson, Trip Advisor and Nordstorm), and small-cap stocks are around US$300 million to US$2 billion (e.g. J. C. Penney and Barnes & Noble). The S&P 500 is an index often used to represent the U.S. stock market, comprised of the 500 largest companies by market cap.
Another term that comes up quite frequently is the P/E or “price-to-earnings” ratio. The P/E ratio is simply the price of one share divided by the company’s earnings per share. The ratio can use the previous year’s earnings (“trailing P/E”) or next year’s projected earnings (“forward P/E”).
In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. In other words, if a company were currently trading at a multiple (P/E) of 20, the interpretation is that you would be willing to pay $20 for $1 of current earnings.
There are a few important details to remember about P/E ratios:
1. A stock with a high price relative to earnings is considered overpriced, while a stock with a low P/E is considered underpriced,
2. High P/E ratios usually imply that investors expect future earnings growth,
3. The average market P/E ratio is 20-25 times earnings,
4. P/E ratios vary among sectors, so it's best to compare like companies, and
5. P/E ratios should not be used in isolation to measure expected returns
Looking at the P/E alone, the metric isn’t meaningful, since the P/E ratio doesn’t capture the growth potential that investors are expecting. That said, P/E continues to be a widely-used measure of value. The price paid for earnings has a powerful relationship with the equity risk premium, or the premium an investor receives for taking on the extra risk of investing in equity. The higher price an investor is paying for earnings, the lower the premium they’re receiving over a risk-free security. Therefore, investors have to decide whether they’re being adequately compensated for risk embedded in a stock.
Putting it into context, FB’s current P/E is 27.07 with a forward P/E of 22.69. But while Facebook was tumbling yesterday, Amazon.com disclosed its largest quarterly profit total in company history, thanks to a surprising performance from their core retail business (this business usually produces razor-thin profit margins, if not losses). Amazon reported revenue of $52.9 billion, up 26% from $37.96 billion a year ago, but slightly lower than analyst estimates (analysts on average were expecting earnings of $2.48 per share on sales of $53.37 billion). That said, RBC Capital Markets continues to love AMZN and reiterated their Outperform rating by increasing the price target to $2,100, which amounts to a $1T market cap (now that you know what that means). But all this hype comes at a costly premium, AMZN’s P/E ratio is 144.21.
Now you are in-the-know with Word on the Street.
Enjoy the weekend,
Investment & Wealth Advisor