The P/E Ratio
If you ever wanted to invest your money, you probably asked yourself, How do I know if the asset I am buying has more value than the price I am asked to pay?
If you didn’t see our previous video on this series, “How to find a value,” you should go and watch it now so you can better understand the difference between price and value and how to find the value of an asset.
There are many Investment Ratios, and each one looks at another aspect of the Asset that the investor is considering investing in.
Familiarity with these ratios coupled with their understanding can get you a long way toward being able to identify those golden opportunities where market prices are only a fraction of the actual value.
One of the oldest Investment Ratios is the one called Price to Earnings also known as P/E ratio.
The ratio is composed of two factors: Last traded Price and the Company’s Earnings (usually annual or 12 consecutive months).
The Ratio asks a simple question: if the company were to provide its investors with all the profits it could generate, within how many years would the investors buying today get their money back. Or in other words, what is the price to value ratio – using Earnings as a value indicator.
From an investor perspective, a good company is worth several times its earnings, simply due to the fact that as an asset is expected to last several years into the future.
A low ratio means Stock buyers are willing to pay less relative to the current earnings.
A high ratio means Stock buyers are willing to pay more for the current earnings.
The Average very long-term P/E Ratio is about 15, which means very broadly and only as a rule of thumb, that investors broadly consider 15 times the current earnings to be a fair price to value.
Bob’s Corner Candy store generates an annual $500,000 in profits. Bob is considering relocating to another city and is searching for a buyer for his Corner Candy Store.
Jack and Bill come along with offers:
Jack, always a gloomy guy, fears the economy is going to head south and is worried the Corner Candy Store Profits might take a hit as a result. Because of that, he considers the real annual profits, heading forward, are only $200,000 per annum. Also, since Jack is worried that Amazon might bankrupt all retailers everywhere by using drones to deliver Candy, he is only willing to pay 3 years of discounted profits – $600,000.
$600,000 for the Corner Candy Store divided by current earnings of $500,000 equals 1.2, meaning that Jack is bidding at 1.2 P/E.
Now, Bill Comes along. Bill takes a tour of the Corner Candy Shop, and he finds that a good percent of clients arrive from out of town to buy Bob’s famous candy and do so relatively regularly.
He also finds the Corner Candy Store has no online presence, although many clients have been pleading with Bob to take orders online.
As Bill drives home, he has a vision: An online Bob’s Famous Candy Shop making, at least, four times what Bob is earning today and possibly more. Bill sees fantastic value and is willing to pay up to four years’ worth of current full earning – 2 million dollars.
$2,000,000 for the Corner Candy Store divided by current Earnings of $500,000 is equal to 4, meaning that Bill is bidding at 4 P/E.
However, Bill forecasts that if he can just earn $1,000,000 from selling candy online to Bill’s demanding clients that his Final P/E is going to be much lower; Take the current shop earnings of $500,000 + online shop $1,000,000 equals $1,500,000. Then divide $2,000,000 that Bill is wiling to pay by $1,500,000 Earnings and you will get a P/E of 1.3.
The next day, Jack offers Bob $600,000 for the business. Bob laughs and sends him home, but is willing to accept Bill’s bid.
Using this example – let’s isolate the factors that might influence a company’s P/E ratio:
- Optimism concerning the likelihood of growth will tend to push P/E ratio up.
- Pessimism concerning the Future earnings will tend to push P/E ratio Down.
- An Increase in Earnings with stagnant price will tend to reduce P/E ratio.
- A Decrease in Earnings with Stagnant Price will tend to increase P/E ratio.
An investor can use the P/E ratio by comparing Relative Price to Value rates today in contrast to the past: for example, City Steel Inc., traded at P/E 24 last year and it is trading at 12 this year. If all things are equal, and the price was stagnant with Earning increasing throughout the period, the investor might correctly conclude that City Steel Inc. stock is at a much better value to buy today than last year and so an even more attractive investment.
An Investor could use the P/E ratio to gain insight on the relative attractiveness of two different businesses operating in similar business segment or industry. He could find, for example, that while City Steel Inc. stock trades at 12 P/E, a competitor, Mountain Steel Inc., trades at 50 P/E. If all things are equal – it would mean Investors of Mountain Steel are willing to pay much more than City Steel Investors.
P/E Ratio by itself, and without a deep understanding of the Fundamentals of the business and its executives, is not a great help. But when viewed from a business perspective by knowledgeable investors, P/E Ratio can become one tool investors use to determine whether the Current Price of an asset is good in relation to Value or not.« Back to Glossary Index