What does the PE ratio mean?

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What does the PE ratio mean?

Post  Max on Thu Dec 23, 2010 2:04 am

Price / Earnings. Lesson over.

Just kidding.

What I want to look at is what does it really mean to you as an investor. Why do you care about this number and what tangible meaning do you attribute to it.

The fundamental assumption in the price earnings ratio is that earnings are the primary driver of stock price. Question is: Which earnings. Past, present, future? Standard PE takes current stock price / current EPS, but this is about as good as taking current stock price divided by historical stock price. It measures only what has already happened. Do current earnings really matter at all in the valuation of the stock price? Really what most investors are concerned with is the future earnings estimates. But future earnings of the company are theoretically infinite. The company will earn money year after year for pretty much forever. So investors are really concerned with how much an infinite stream of earnings will be worth in today's dollars. How do you predict with any accuracy an infinite stream of earnings when you can't even forecast 1 year's earnings with any certainty? Looking at these issues, the PE ratio begins to become an abstraction and gets difficult to interpret.

By taking the PE ratio and breaking it down, we can see that if a stock has a price of $100 and the EPS is $10 per year, then the PE ratio would be 10. This means that it will take 10 years for the stock to earn enough to pay back the shareholder that bought it (again, PE ratio ignores book value, dividends, etc, and considers only EPS. Now, take 100% of the purchase price repaid divided by this 10 year repayment period, and get a result of 10% annual return. Now we have a number we can use! I can compare this to the return I can expect to earn on GICs (3%), and determine that yes this would be a good stock to invest in. This 10% annual return can then be projected into the infinite future. 10% annual return sounds good to me.

I would argue however, that earnings (even if we assume they are accurately forecast to infinity) do not make up the entire stock price. There is already some value in the company even if they make no earnings at all. If I were to buy a company with no earnings but $100 per share book value. According to PE ratio, earnings are all that matter, so this stock would be worthless. Obviously this is not the case. To properly assess PE, I think you would have to separate the book value component from the stock price. You should then take (book value component / total stock price x 0% return) + (earnings component / total stock price x (100% / (earnings component / EPS)), which will result in your annual rate of return on investment. Splitting the return in this way really reflects the amount of capital you need to invest in order to buy the infinite earnings stream of the company. Paying $50 for EPS of $1 and book value of $30 is like saying you are investing $30 into the assets of the company and the $20 difference is a premium reflecting the current value of that infinite income stream of 5% (100% / ($20 / $1)). Since the book value is a fixed component of the stock price, you cannot make a profit off of book value unless the stock price is below book value. As long as the stock price is above book value, you only need to decide if the earnings stream combined with the working capital cost of the $30 investment in assets is a good return or not. In this case, at ($30/$50 x 5%) + ($20/$50 x 0%) = 3%, I think I would pass on this stock, since I can make almost as much in a risk free GIC.

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