P/E Ratio Defined

June 14, 2008

This is the second part of a three-part tutorial on measuring a company’s valuation. You can find Part 1 here. Part 3 is coming soon.

What is P/E?

Short for “Price to Earnings ratio,” P/E measures the “value” of a stock by comparing the cost of that stock with the earnings allocated to it. Remember back to Part 1, we explained that a share of stock represents a fractional share of ownership in a company. Companies are in business to make a profit, after all. If the purpose of a company is to earn a profit, the purpose of owning a piece of the company is to own a piece of its profits.

The P/E ratio—-which compares the Price per share of stock with the Earnings per share—-is a simple way to understand “how much” the stockholder is paying for his share of profits.

An example: for 2008, analysts anticipate IBM will earn about $12 billion profit. Divide $12 billion by the 1.4 billion shares of IBM stock outstanding and that works out to about $8.60 of earnings per share. If I own 100 shares of IBM stock, I own $860 of IBM’s 2008 profits ( 100 X $8.60 = $860 ).

But in order to own my $860 of IBM’s 2008 profits, first I have to buy 100 shares of IBM stock. At $125 per share, that will cost me $12,500.

Why pay $12,500 for shares of stock that only entitle me to $860 worth of profits? Because, of course, I’m entitled to more than $860. Assuming IBM isn’t going out of business on 1/1/09, the company will continue to make profits after 2008.

This is a crucial point to understand: a share of stock is a claim on company profits as long as the stock remains outstanding and the company remains a going concern. If IBM continues to make $8.60 per share every year, then my $125 investment will be paid back in precisely 14.53 years. ( $125 / $8.60 = 14.53 ).

Attentive readers will have already made a connection with the P/E ratio. If a price of IBM stock is worth $125 and earnings per share are $8.60, then the P/E ratio equals, you guessed it: 14.53. So the P/E ratio signals investors how many years it will take for their initial investment in company stock to be paid back with actual company profits. All else equal, the higher the ratio, the longer it will take for me to earn back my investment.

But all else isn’t equal in the real world. Companies don’t tend to earn the same amount of profits per share every year. If management does its job, earnings per share should grow every year. Depending on the growth rate of earnings, it may take less time for my investment to be paid back. Say, for instance, IBM is growing earnings precisely 8% each year. In this case, it will take just over 10 years to earn back my $125 investment:

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If IBM were growing earnings 30% per year, the payback period would be a little over 6 years. BUT, the 6 year payback period assumes IBM stock was still trading at 14.5 times this year’s earnings. In the real world, a company growing earnings that quickly is likely to fetch a far higher P/E multiple.

This is a crucial point to understand: companies with faster profit growth will tend to trade at higher P/E ratios because investors are receiving more earnings with each passing year.

IBM isn’t growing earnings at a 30% clip. But a company like Google is. According to Yahoo Finance, the consensus view of Wall Street analysts is that GOOG will earn $20.12 per share this year, up nearly 30% from last year’s $15.59.

At yesterday’s close of $572 per share, Google stock is trading at a P/E ratio over 28, which means if the company is unable to grow earnings after this year, it would take investors 28 years to earn back their initial investment of $572 per share. But Google is still growing like a weed. Compared to IBM’s anticipated growth rate of 11% over the next five years, analysts think Google will grow nearly 30%.

But even with 30% earnings growth EVERY YEAR, it will take Google over 8 years to pay back investors. That’s because investors are paying more for Google stock to begin with, 28x earnings to be precise.

Google may be a great company, but it’s a longshot to grow earnings 30% per year for the next 8 years. Total company profit would increase from $6.3 billion in 2008 to nearly $40 billion in 2015. That’s an awful lot of money to make from advertising…

Many argue there’s no way Google could make that much money in 2015, and therefore, trading at a P/E ratio of 28, the shares are “overvalued.”

But now we’ve left the realm of objective investment fact and entered the twilight zone of investment opinion. Saying that a company is “over” or “under” valued is totally subjective. Much of the financial services industry is paid to invest in “undervalued” stocks/bonds/real estate/art/whatever with the hope that, one day, such assets will achieve a higher valuation and be sold at a profit.

It’s hard to question some opinions regarding stock valuation, unless of course those opinions are misinformed. Indeed, I introduced this series of tutorials on P/E by noting valuation analyses based on it are often incomplete. There is a better way, which I will explain in Part 3.

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