The ratio of a stock’s price to its company’s earnings is so vital that most major newspapers allocate precious space on their crowded financial pages to publish the figure, right next to the day’s high, low and closing prices. As important as the number is considered to be, it’s apparent that few people have been paying much attention to it of late, even if they know why they should. But then, why should they? Let’s talk about it.

The concept of the price/earnings ratio (P/E or “multiple”) is worth exploring in some depth because it can tell you a lot about the reasonableness of a stock’s price. While meaningful enough by itself, it’s even more revealing when considered in context with other data.

It’s a measure of investor confidence, a measure of time, a measure of value, and arguably the most meaningful way to express a stock’s price. To the long-term, growth investor, it offers a way to watch the all-important relationship between a company’s earnings, the underlying driver of a company’s stock’s true value, and the price investors are willing to pay for its stock – a sometimes extremely volatile measure of its perceived value. Tying an elusive stock price to a firm figure like earnings is like trying to anchor a cloud to a rock, but it can be done — and understood!

What’s the Value of the Business You’re Buying?

Anyone interested in buying a business measures its value by its ability to generate income and will pay a fairly predictable multiple of that income to own that business. For a small business, this multiple is generally the equivalent of the length of time it will take to recover the investment and begin to produce unencumbered income for the purchaser. Thus, a fair price for one kind of a business might be about five times the annual income, implying that the purchaser could expect to recover the investment in as many years.

For obvious reasons, a company that is capable of increasing its income—because it can effectively put its surplus to work to generate additional income—can command a higher multiple. This is because it can recover the larger investment in the same reasonable time.

Buying shares of stock in a company is no different, of course, since the P/E is calculated using the per-share data derived from dividing both sides of the equation by the number of shares outstanding. It stands to reason, however, that higher multiples are common with the established, successful and growing businesses you’ll invest in. With successful companies whose revenues already exceed $100 million, you’ll have few of the risks and responsibilities that go with buying a small business you’d have to run yourself. Therefore, it’s reasonable to pay a premium — from 10 to 20 times earnings and sometimes more — for such companies. The higher the rate of growth, the higher the multiple that can be justified because, again, the time it will take to recover your investment is shorter.

The notion of the P/E as a measure of time should be helpful in contemplating the P/E as more of an absolute rather than a relative measure of value. Viewed from this perspective, it should be obvious that multiples of 100 or more mean that you’d have to emulate Methuselah to ever recover your investment. Quite obviously, then, making money on a company whose stock you purchase for an excessive P/E requires reliance on the “Greater Fool Theory” which states, “I may be a fool to buy this stock at this price; but I’ll find a greater fool to take it off my hands!” As many unhappy investors have already found, it’s all too easy to wind up being the “fool” that’s the last to buy in this scenario.

If the P/E is to be a helpful measure of value, how can one determine what is reasonable? This is particularly poignant when we look at recent history. For nearly half a decade, investors – many having been professionals who should have known better — have fallen prey to the “irrational exuberance” that Fed Chairman Alan Greenspan referred to, and have paid exorbitant multiples.
How can we make an intelligent assessment in view of this? To come up with a rational answer to this question, we’ll need to look still deeper into the dynamics of the P/E.
In the next installment, we’ll talk about why the P/E is such a valuable tool for forecasting.

Continue to Part 2 >>