The Price Per Earning Ratio

What is Price? What is Earnings? What is the Price-Earnings ratio? Why is it so important and what does it mean for investors today?

What is Price?
Every single share sells for a price. The price is what the company would sell for on the open market. Commodities generally sell its intrinsic value. The pricing of a company is slightly more complicated because you are not merely speculating on its intrinsic price in the future but also on its growth value.

What is Earnings?
Since businesses generally earn profits its intrinsic value grows over time. This means if a company is selling for $1 today but is expecting to make $1 tomorrow a buyer may buy a share for $2. If the buyer is willing to wait 3 days the business may now be worth $3.

What is the Price-to-Earnings Ratio?
The price-to-earning ratio (or P/E for short) is the price divided by the earnings. In other words, what the share sells for today and at what rate the share may be worth more.

Why is it so important?
Consider for a moment that the buyer may not be the only one buying shares. Millions of more offers may come in with Investors with different time horizons. Additionally, the general sentiment in the market may favor different P/E ratios. Now you are not only betting on price but at what valuation investors will pay in the future.

The Math
Today the Dow Jones Industrial Average sells for 13,265. This is high considering it once sold for less than 5. Actual earnings of all 30 companies this quarter was 645. This means that the Dow is selling for a little less than 21 times earnings. It also means that even if the companies’ profits were to remain completely stable, the Dow can fall to 645 and still maintain its intrinsic value.

Margin of Safety
Ben Graham, the father of value investing, said to always buy below a P/E of 15. The investor must also consider how much earnings themselves will grow by but must be careful not to over valuate.

The reason for this figure is simple. Over decades of market history the most that the average share has sold for in times of a good market has been 30. Conversely, the lowest common valuation given for a bad market has been 7.5. This brings us to an exact median figure of 15.

This enables us to maintain an adequate margin for safety. While a share of say $10 at a P/E of 15x may fall to 7.5x (a loss of 50% – halving its investor’s capital), it may also sell for 30x (generating a profit of 100% – doubling the investor’s capital).

An Example in The Market
This is an example of what a typical conversation would sound like between an eager seller and a potential but cautious buyer.

Seller: I would like to sell my shares for 20 times earnings.
Buyer: Are you crazy? That means that you are betting that earnings are going to continue like this for 20 more years.
Seller: So, what’s your point?
Buyer: And you are willing to hold onto those shares for 20 years?
Seller: Well if I sold them for less, then I’m betting that earnings may drop sooner.
Buyer: And, what’s your point?
Seller: That earnings may continue for 20 years and may not! How do I know how much earnings will increase over time?
Buyer: Welcome to the marketplace buddy!

What This Means for Investors Today
We are in what is known as a Secular Bear Market. This is when P/E ratios are generally falling. Remember that this may happen even though earnings may be rising. Therefore, the stock investor must now find good companies, with increasing profits that are selling for prices that have already filtered in any possible decline. While this is very easy when the ratio is low (below 10), this gets very complicated when the ratio is high (above 20).

As the ratio falls companies will become cheaper, bringing more long-term investors into the market while driving the short-term speculators out. This one of the reasons why many investors do better when prices are falling than when they are rising.

“Fools are those who know the price of everything and the value of nothing.”

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