Back to the basics: the P/E ratio

By: ispeculatornew
Date posted: 08.27.2010 (5:00 am) | Write a Comment  (3 Comments)

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In the newsletter that we sent last week, we asked readers for suggestions and questions and one recurring theme was that it would be nice to review some more basic concepts so I thought one of the best ones to start with would be the P/E ratio or Price/Earnings. Why? Because it is one and perhaps the criteria that I use most when selecting stocks or to evaluate valuations but I have never given a good explanation of what it is, what it represents, etc.

What is it? Lemonade stand example

Up to this point, I have written assuming that readers are familiar with the P/E ratio but the fact is that it’s not the easiest concept and I think going back to an easier example would be a great way to better understand it.

Is there a lemonade stand or store near your house? Imagine that the workers at the stand are paid on a daily basis and do not get “profits”, for simplicity purposes. If the lemonade stand has been making 100$ per year for 10-20 years, you can probably assume that it will remain the case in the future right? How much would you be willing to pay to own the stand and the profits? If you consider that a 10% return would be good enough, you would be willing to pay 1000$ for the stand.

In this example, the price paid (1000$) is 10 times higher than the annual profits so the P/E ratio would be 10 (1000$/100$). Makes sense?

Different types

In the previous example, the lemonade stand is generating the same profits year after year. But imagine if the stand has been and continues to generate growth of 10%. You could expect profits for next year to 110$. In that case, the 1000$ price for the business would represent a  9.1 P/E ratio. This would be the “Next Year’s P/E ratio“.

How important is growth when comparing P/E’s?

Obviously, growth is crucial when looking at P/E ratios. Why? To go back to our example, it’s easy to see how the stand that can increase its profits by 10% per year will make a huge difference over a few years.. After 5 years, that business would be generating over 160$ of annual profits. Obviously, if you paid 1000$, the return of 160$ per year would be significant. That is why it is critical to consider growth when comparing the P/E ratios of different companies. I spend a lot of time comparing P/E ratios of different companies but if you are not taking into account differences in growth, there really is no sense in even doing the exercise.

Downsides to using P/E

Of course, using a P/E ratio has its flaws, here are a few:

-If the lemonade stand is making no profits or actually losing money, it becomes very tricky to use P/E ratios. The best way to do it is to project profits for next year or two years from now, then compare those ratios but it remains a imprecise science
Does not consider earnings quality. When companies have “one time” items that can affect the “Earnings Per Share”. If those earnings will not repeat in the future, it can become difficult…
Does not consider the assets and debt of the company. I’ve been looking into ways to better include this in my stock picking. A company like Yahoo has little earnings and honestly I do not see that changing much in the future. But if the company has billions of dollars in the bank, or if it had huge debt, it should be considered obviously but a P/E ratio would not be able to do that.

Why I still use it so much

I agree, I could never trade only with a P/E ratio but:

1-I still think it’s one of the best ways to compare valuations of companies, which is critical in long/short trading.
2-Once you add growth and assets & debt, you can get a very strong feeling of a company’s valuations and value
3- I think that over time, you can learn which companies are reliable in terms of P/E ratio and which ones are too volatile

Where to find it?

The best place to find P/E ratios is on Google Finance or similar wwebsites. Here is a screenshot:

You will not get “Forward looking P/E’s” easily since they depend on future earnings estimates.

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