Price Earnings Ratio

The Price Earnings (P/E) Ratio is a well known and easily computed number regarding the value of a company.  Yet, it's really not that well understood.  What exactly does a P/E of 14 indicate?  Is it better, or worse than a P/E of 16?

The way I see it, there are two main components that make up the P/E ratio, and they are not price and earnings - well, they are - but, if you slice it another way then you get two more revealing components.

The two components that I see in a P/E ratio are growth and cheapness.  It's unfortunate that those two components are munged into a single number, because what an investor really wants to see are those two components separately.

To illustrate why I think that growth and cheapness (I could use the word "value", but that would lead into a whole other discussion), let's consider the case of a zero growth company.  How would you value a company that was known to have no growth? 

Recently, I was fortunate enough to find out.  A friend of mine runs a bar/cafe and his 50% silent partner was selling his half of the business.  "Great" I said to him - "So you had a chance to get a valuation on your half of the business.." "Meh", he replied: "I know what the turnover is, so I know what the business is worth".  He went on to explain to me that, on average, bars & cafes sell for 3-5 times their earnings - because - that means that the new owner has to work for 3-5 years before he has paid for the business - after which he in profit land.

That sounded reasonable enough.  On average, you work for 4 years, after which point you get to keep all of the profits.  Thus, a P/E of 4 is about what you can expect for a zero growth business - because - that's how many years you have to wait for your earnings to pay off your capital outlay.  Note that the lower the number, the less time you have to waiting for profitability, therefore the "cheaper" it is.

So, why then do companies sell for an average P/E of 14-16 on the stock market.  Well, the other factor is of course "growth".  My friend's bar/cafe was a zero growth business.  The same people went there week-in week-out, all year round (Not quite, but you get the drift).   The reason that some companies sell for P/Es in the 30-50 range is not because people are willing to wait 30-50 years for their money back - it's because the company is growing its profitability each year - probably exponentially - or at least - people have that growth expectation.

Considering then that a company may be growing at a rate of 10% per year, today's P/E would be higher (than 4) to reflect that expectation.

So, next time you see a P/E value of 10, the first question to ask is "what is the growth rate of this company?", because if there is zero growth then a P/E of 10 is a bit expensive.  You would need to wait 10 years before your earnings would pay off the capital outlay.  However, with solid growth prospects behind a quality company, a P/E of 10 is likely to be a bargain.