The PE Ratio – Its Importance as an Investment Tool

We believe that one of the most important and useful tools for the serious investor, is the price earnings ratio or PE.  It is, however, one of the most misunderstood and misused tools. We believe that learning how to use it properly and understanding its importance can significantly increase returns and lower risk.  Perhaps the most important thing to realize when using the PE ratio as an investment measurement is the PE ratio by itself is virtually worthless.  The PE ratio is only truly important when thought of in relation to the respective company’s earnings power, past, present and future.

Therefore, the true value of the PE ratio is as a barometer or measuring device used to calculate and measure important investment metrics relative to each other. Unfortunately, we have found that many, if not most investors, fail to realize this and therefore miss the long-term benefits that PE’s offer. On the other hand, when the PE ratio is thought about and used properly, it can greatly assist the investor in the rational evaluation of the realistic probabilities of achieving a long-term rate of return and the amount of risk taken to get there. In short, when used properly, the PE ratio can help investors ascertain both current and future valuation.

The PE Ratio Defined

A great way to gain a deeper insight into the value of a PE ratio is by evaluating several common definitions where each provides a different perspective and greater clarity. In other words, the PE ratio can be defined in several ways, with each definition adding insight into its usefulness. For purposes of this article, we will offer three of the most common PE ratio definitions as follows:

1. The simplest and most common definition is the price of the common stock divided by its earnings per share.  This basic mathematical definition is expressed as follows: price/EPS = PE ratio.  Although this definition is the mathematically correct way to express a PE ratio, we believe it adds very little insight into the relevance of the PE ratio.
2. A second commonly used definition that we believe offers deeper insight is: The PE ratio is the price you pay to buy one dollar’s worth of the company’s earnings or profits.  For example, if a company’s stock has a PE ratio of 10, then you are paying \$10 for every dollar’s worth of that company’s earnings or profits you buy.  If the company’s PE ratio is 20, then you are paying \$20 for every dollar’s worth of the company’s earnings or profits, and so on.

This second definition more clearly addresses the cost of the earnings the investor is purchasing. However, as we will later elaborate, a PE of 20 may not necessarily be more expensive than, for example, a PE of 15.  If the company with the higher PE is growing significantly faster, it is simultaneously generating a much larger future income stream.  And thanks to the power of compounding, the investment with the higher PE of 20 may be actually purchasing future earnings much less expensively than is the investor that is buying a much slower growing company at a PE ratio of 15. This provides insight into the concept that the PE ratio is a relative tool.

How much you are actually paying for future earnings is a function of how fast current earnings are growing. The faster a company grows, the larger will be the future income stream to discount. Therefore, a faster growing company will logically be worth more than a slower growing company, and as a result, command a higher original price or valuation.  This relationship to a company’s ability to generate earnings and cash flows on behalf of its stakeholders is a critical element towards understanding fair or intrinsic value. However, it’s also important to add that the stock market (Mr. Market), at any given moment in time, may not be applying a PE ratio to a company that reflects its intrinsic value.

This is why it’s so important to understand the dynamics behind what the PE ratio is actually supposed to reflect. In other words, it behooves the investor to be able to recognize whether the current PE ratio reflects fair valuation, overvaluation or undervaluation. The simplest way to do this is to measure the current PE ratio relative to your most reasonable expectation of the future growth of the company’s earnings.  The best way to do this is to utilize established formulas for valuing a company’s future cash flows. In essence, these formulas answer the question: What is the present value of a given expected future stream of income?

3. Our third and final definition is:  The PE ratio states how many years in advance you are paying for this year’s earnings.  For example, if a company has a PE ratio of 20, then you are paying 20 times this year’s earnings to buy it.  If the PE ratio is 10, you’re paying 10 times this year’s earnings, and so on.  The key to understanding the significance of this definition is based on the simple premise of how an operating business derives its value.  The foundation of this premise is that a business generating an annual revenue stream for its owner has a value greater than one year’s worth of profits.

The question then is; How much more? Here are a few clues; the yield on a 10-year Treasury bond has averaged 6.1% since 1950. Therefore, even the no growth income stream from a Treasury bond is worth 16 times its annual income (cost of 100 divided by average yield of 6.1% equals 16.4 price to interest ratios). Also, the average PE ratio of the S&P 500 has been approximately 15. In other words, a no, low to average growing revenue stream is hypothetically worth at least a multiple of between 15 and 20 times.

Using the PE Ratio as a Measurement of Valuation

Now that we have offered our three definitions of the PE ratio, let’s evaluate how we can use this information to become better investors.  In other words, we now know what a PE ratio is, but what we need to know is how to effectively use it to make smarter investment decisions. There are several factors that come into play here, most of which are mathematically based, while others are based on commonsense realities that cannot be ignored. However, in all cases the real value of the PE ratio comes with using it to measure the cost or price you are paying to purchase your expected future income stream (earnings). Obviously, just like buying anything else, the cheaper you can buy future earnings, the better. But most importantly, this establishes the need and the necessity for investors to forecast future income streams as accurately as possible.

Forecasting Future Earnings is the Key

As an investor, forecasting future earnings is the key to long-term success. We cannot escape the obligation to forecast; our results depend upon it.  However, our forecasts should not be mere prophecy, and we should not be simply guessing.  Furthermore, forecasting should not be about playing hunches, instead investors should be attempting to calculate reasonable probabilities based on all

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