Recently I ran into a long time reader who asked if I would re-post an old series I wrote on the P/E ratio. I wrote this when the blog was not yet a year old and didn’t have many readers so I thought it might be worthwhile to dig it up. Be warned, you may want to grab a cup of coffee before sitting down to read this. It’s a bit lengthy, but this is something that gets talked about all the time in the business news so I think it’s worth having a cursory understanding… Enjoy.

The P/E Ratio, also known as'

The P/E Ratio is such a widely used ratio that it has many different slang terms such as:

1. The Multiple
2. The Price to Earnings Ratio
3. The P/E Ratio
4. Earnings Ratio
5. Price Multiple

'and there are probably some others that aren't top of mind right now, too.

Okay, so what is it?

The price to earnings ratio is a number that is derived from the formula:

P/E Ratio = Price Per Share / Earnings Per Share

So the 'P' stands for the Price of the share, and the 'E' stands for the Earnings Per Share (or 'EPS'). If you had a stock that was trading at $50 per share on the market, and that stock had an EPS (earning per share) of $2.50, then according to this very simple formula, the P/E Ratio of this stock is 20 ($50 / $2.50). So calculating the P/E ratio is butt simple.

But seriously Preet, what IS it?

There are a number of differet ways to look at it, but I will give you the one that makes the most sense to me.

It is the price you are willing to pay today for $1 of annual income in perpetuity.

So for example, for our sample stock above with a P/E of 20, that means you are willing to pay $20 today for an annual income stream of $1 for life. (It might be better to say that the market as a whole is willing to pay $20 today for that $1 annual income for life.)

I'm going to borrow an example I read elsewhere, but if a stranger came up to you and asked you to buy a $1 dollar income stream from them for life, you would have no idea if they were able to keep this promise and you might only offer them $1 simply because you don't know or trust this person, but you think that you should be able to at least get your $1 back next year. But what if Bill Gates came up to you and offered to sell you $1 per year for life for $20? You might take him up at that price because you know that he will probably be making a lot of money for many years to come. Well, in essence Bill has a P/E ratio of 20 and the stranger has a P/E of 1.

Your expectation of Bill Gates earning lots of money in the future is solid and hence you are willing to basically wait 20 years to get your money back, at which point the future $1 annual income is gravy. (Clearly I'm not factoring in opportunity costs or interest for this example ' but I will in a follow up post that is a bit more technical.)

Let's now relate it back to the stock market

A high P/E ratio means that investors believe the future earnings of a company are expected to be strong. The stronger the earnings outlook, the more confidence people have in buying stock in the company because they believe there is a greater chance that the earnings will continue.

If someone offers to pay a higher price for a stock, they are offering to purchase the stock at a higher P/E ratio ' which means they are more confident about the future of that company.

But there's more'

When a P/E ratio really starts to get high this is due to investors not only believing the earnings are solid, but that they will probably GROW over time as well. This means that they are basically saying to themselves that they believe the $1 annual income stream will increase. Next year it might be $1.05, the year after it might be $1.12 and so on. Since they believe the earnings will grow (because the company is going to take off), they are willing to offer an even higher 'multiple'. For example, RIM has a P/E of over 60 right now (Remember, this was originally written in 2008 – Preet). If you only assume that you are buying $1 of annual earnings per year for $60 today, that might seem a bit crazy. But if you think that RIM will continue to increase it's earning VERY rapidly, then you are not expecting $1 per year, but rather a very quickly increasing earnings stream.

RECAP

The P/E ratio can be''considered as the price today of purchasing a $1 income stream for life. When people bid up the price of a stock, and hence''the P/E ratio, they are basically saying that they believe that company's future earnings outlook are more promising, and are willing to pay more to own a piece of those future earnings.

So What's A Fair Price For A Company?

Let's assume we have a company that is guaranteed to provide $1 per year for life no matter what (i.e. there is no business risk whatsoever ' purely wishful thinking!). In this case, what would be a fair price to purchase that income stream? Well, if we assume that we are going to live for another 80 years, then you might say $80 as a starting point because 80 years times $1 = $80. You would think, I'm going to get $80 over the next 80 years ' therefore this is the fair price. Right?

Wrong.

The Present Value of a Dollar From the Future

You are essentially giving up $80 now in a lump sum today in exchange for getting eighty $1 dollar payments over 80 years which is crazy when you think that you could just get a high interest savings account and get 3% interest on your $80 lump sum starting today [Ah, the good old days - Preet]. In fact, the first year's interest alone would be $2.40 ' that's much more than $1. And after 80 years, your original $80 dollars would've grown to $826.48, if you kept re-investing the interest.

Let's start by figuring out what a better price would be to pay for a series of $1 payments that will be received in the future, starting with next year. Basically, we need to start by asking:''What do I need to invest at 3% today, to get $1.00 in one year?

In this case, the answer is $0.97 (rounded). In other words, to have $1.00 NEXT year, you would need to invest 97 cents into that 3% high interest savings account. Therefore, you might pay $1 for this year's $1 income from the company, but you would definitely not want to pay more than $0.97 for next year's $1.

Let's move to year 3. What would you need to invest TODAY at 3%, in order to get $1 in 2 years? The answer is $0.94 (again, rounded for simplicity's sake). $0.94 invested for one year at 3% equals roughly $0.97, which when invested for the second year at 3% will give you $1.

So you can see, the further out that company's $1 annual income is, the less you would want to pay for it. If we fast forward to year 80, you would only need to invest 9 cents today in a savings account that paid 3% interest per year in order to have $1 eighty years from now. So it would make no sense to pay more than 9 cents today for $1 to be received in 80 years.

Below, I have charted the present value of $1 for every year between now and 80 years from now, based on a 3% interest rate. If we add up all of those values, we then have $30.20. Therefore, assuming there is no business risk, and we are guaranteed an earnings of $1.00 per share every year for the next 80 years, $30.20 per share is a much fairer price than $80.00 to pay for this income stream.

Still Not Done!

We are not quite yet done with the discussion. There are two more things we need to factor in. 1) Investors expect to be compensated for the risk they take in making an investment that is more risky than a high interest savings account (this would bring the price'' that they are willing to pay DOWN), and 2) the price goes up if the company's earnings are expected to increase.

So far we been using some unlikely assumptions, namely that this fictitious company we are going to buy has a constant earnings stream and that there is no risk involved in that earnings stream. Of course the real world is quite different. Let's next decide on how a changing earnings stream can affect the present value of all those future annual earnings.

The Math is Not Much Different

The math is not really different, we just have to take an extra step. Before, we were just assuming that a company would produce $1 in annual earnings forever. But let's now pretend that our company is expected to grow it's earnings by 10% per year. Therefore, instead of an earnings stream that looks like this:

Year 1: $1.00, Year 2: $1.00, Year 3: $1.00' etc.

It will instead look like this:

Year 1: $1.00, Year 2: $1.10, Year 3: $1.21' etc.

If we just do the math for the first 3 years, you will get the picture of how a changing earnings stream can affect a price someone is willing to pay for a company. If you recall, we need to figure out what we need to invest TODAY at 3% (or whatever the 'risk-free' rate of return is) to replicate the earnings that will be earned at some point in the future. In our new company here that grows it's earnings at 10% per year we find that we might pay $1.00 for this years $1.00. But it is going to earn $1.10 in the second year ' so what amount of money invested today at 3% will give us $1.10 in one year? The answer is $1.07. Likewise for the $1.21 it is expected to earn in Year 3 ' what amount do we need to invest today at 3% in order to replicate that $1.21 in two years from now? The answer is $1.14.

At this point, I could show a revised graph which shows the present value of the income stream for a company that can grow it's earnings at 10% forever, but not many companies can do that. What is more realistic is to look at the following situation:

A Hypothetical Company's Life Cycle

Suppose we have a relatively new company that is turning a profit and is still in it's growth phase. During this growth phase it is expected to grow it's earnings at 20% per year for 5 years as it gains market share and more customers. After the first 5 years, earnings growth slows down to about +10% per year for the next 5 years, and then slows down to +5% for the next 5 years. At this point, it has reached it's market saturation point and perhaps earnings hold steady for the next 10 years. During that time, some competitor companies figure they can take a slice of their market and start up operations, and over time start to move some customers over away from 'our' company. Our company therefore experiences an earnings''decline of -5% per year for the next 10 years. At this time, our company and the competitors have found an equilibrium point and our company's earning are now not declining further, nor are they increasing from this point on until the end of the 80 years.

The above Life Cycle might represent a more realistic earnings stream for a real-life company. Now that we have a projection of what the future income stream might look like, we can again add up all the present values of those annual earnings to figure out a fair price for those earnings. I have charted both the annual earnings (in red) and the present value of those future earnings (in green).

If we add up all the present values this time we get a sum of $71.81. This is quite a bit higher than the $30.20 we came up with in part 2, but remember part 2 assumed $1/year for 80 years. Whereas in this case, the earnings grew from a start of $1/year to as high as $3.55/year, and then declined to about $1.56 per year.

So you can see how earnings predictions are so important and why the market seems to be so sensitive to them.

What About The Business Risk Preet?

Ah, yes. Again we have yet to factor in that if we were to offer $71.81 for this future earnings stream, we are assuming there is no risk involved ' and of course, this couldn't be further from the truth. There is the risk that this company goes out of business due to competition, their product could be rendered obsolete by new technology, a poor economy in general, you name it. Any of those things could affect future earnings and there is a risk that our predictions for the income stream may not be fulfilled. We could put our $71.81 in a high interest savings account at 3% and basically replicate this earnings stream with no risk, therefore we would be crazy to offer $71.81 for this company ' we would have to offer LESS money for this expected income stream to compensate us for this extra risk.

If you offered $40/share for something you have calculated to be worth $71.81 today, this discount represents the compensation for the risk you are taking. The constant bids/asks on the stock market for shares of companies are basically people weighing in on what their perception of a good discount is for that future earnings stream for those particular companies.

Putting It All Together

So far we have basically explained that''the P/E ratio is a way to guage what investors are willing to pay for the future income stream of a company, and how much of a discount they wish to receive in exchange for accepting the risk associated with that income stream.

But the P/E ratio is far from an exact science ' it is more of a black art. How accurate are analysts' predictions about earnings two years from now, let alone 80 years from now like in our example? Think of it like throwing darts except replace 'year' with 'feet from the dartboard'. Predicting earnings for 1 year (throwing a dart from 1 foot) is much easier than predicting earnings 20 years from now (like throwing a dart when standing 20 feet away). There are just too many things that can happen to change the future fortunes of a company.

So how do people use the P/E ratio?

The P/E Ratio, like many other stock analysis tools and metrics should be used as part of your analysis, not as the basis of your analysis. I would use it to raise red flags, not to screen investments. People generally look at a P/E ratio and compare it to the P/E ratio of something relevant. That 'relevant thing' could be the historical average P/E of the stock in question or the average P/E of all the similar companies in the same industry.

If the stock's current P/E ratio is much higher than it's average, this might be referred to as being 'expensive'. It might also mean that the company is expected to grow it's earning faster than it has previously. The fact that the P/E is higher than it's average means nothing in and of itself.

Conversely, if the stock's P/E ratio is much lower thant it's historical average, this might be referred to as being 'cheap'. It might also mean that the company is expected to have lower earnings than previously thought. Many value-investors would look at a low P/E ratio as a good thing if they believe nothing has changed with the company since they would consider a value stock as a company that is temporarily undervalued for no good reason (which a lower than average P/E ratio might suggest). The classic value trap is when the P/E ratio is low, making the stock look cheap, and value investors pounce only to find out that something is indeed wrong with the company and the earnings decline and the stock price follows.

Comparing Relative P/E Ratios

Where knowing the P/E ratio can be of more use is when comparing the P/E ratio of a company against it's competitors with similar characteristics, the market as a whole, or as mentioned above, against it's historical average.

Different companies in different industries may have higher or lower P/E ratios based on what kind of company they are. For example, the big blue chip stocks (like a utility company) might have a low normal range of P/E ratios because they are more mature and are not expanding anymore ' their earnings may not be growing as fast as a high-tech company that arrives out of nowhere and expands and grows furiously. However, a high-tech company with a P/E ratio of 30 might be cheap, whereas a bank with a P/E of 20 might be expensive ' it's all relative.

The Market P/E Ratio

The market P/E ratio is simply the total market capitalization of all stocks in the market divided by the total earnings of all the companies in the market. Some people use the market P/E to make decisions about whether the market as a whole is 'cheap', 'expensive' or around it's long term average. They may choose to avoid picking any stocks if the market is expensive because sometimes the baby gets thrown out with the bathwater (meaning that during market declines, sometimes it doesn't matter what you own, it might be going down too).

The End

Well, sort of. I think from reading this you will have a firm grasp of what the P/E ratio is, and how it gets used in the financial press. As always, if you want to learn more a simple google search on it will yield years of reading material as it is one of the most used financial ratios in the business.

Peace out